Credit Swap Derivatives: What You Need to Know

Introduction 

Credit derivatives is a major investment tool which include contracts, swaps and other options that allow users to transfer default risk from one party to another. They consist of privately held negotiable contracts where the price is determined by the credit risk of the agent e.g. the government or private investors (Anderson, 2010). The value of the derivatives depends both on the quality of the party that requires the loan and the credit quality of the protection party; however, the credit of the latter is of primary concern. If the protection party does not fulfill the derivative contract, the lender of the loan does not get paid, and the premium ends. There are two main types of derivatives namely; funded and unfunded credit derivatives. In funded credit derivatives, the protection seller pays money at the beginning of the contract used for any potential credit events that occur during the contract period. On the other hand, in unfunded credit derivatives, each party participating in the contract is responsible for making its payments under the contract (Anderson, 2010). Both funded and unfunded credit derivatives provide assurance to investors that the stock price will not change. There are three types of credit derivatives which are credit default swaps, total return swaps, and collateralized debt obligations. Other types of credit derivatives include; asset swaps, and credit linked notes 

Credit Default Swaps 

The credit default swap (CDS) is the most used form of credit derivative where there is financial agreement that the seller of the CDS will pay the buyer for any credit expenses. Its purpose is to transfer the credit exposure of fixed income products between two or more participants; it acts similarly to the insurance policies issued by banks and taken out by third party investors. This type of credit derivative has become the cornerstone product in the market; its value depends on the credit worth of the underlying reference entity and the credit worth of the counterparty. If the counterparty fails to honor the payments, the buyer of a default swap will not get paid and the premium payments ends. Purchasers of the credit default swaps can avoid risks on their expenses without necessarily selling them. On the other hand, the sellers can get more returns from such investments by pursuing difficult markets (Young, McCord & Crawford, 2010). CDS is composed of four types which are; credit default swaps on single entities, credit default index swaps, credit default swaps on a basket of entities, and first-loss and tranche-loss credit default swaps. 

Total Return Swaps 

Total return swaps (TRS) is a financial contract between two parties that transfers both the credit and market risk of all variables to one party. However, the party supposed to pay for the all the credit events during the contract can avoid all the economic expenses of the property without selling it. On the other hand, the party getting paid can access the financial expenses of the asset without necessarily purchasing them. For instance, a bank that has books of loans may decide to minimize the financial cost of its loans while still retaining the customers with the loans. To achieve that, the bank can use the total return swap with another party that wants to gain economic benefits in the credit market. Total return swaps allows investors to benefit from all the cash flow benefits of security without actually owning it (Young, McCord & Crawford, 2010). At the end of the total return swap, the investor must pay any decline in price to the TRS payer; if there is no decline, the investor is not obliged to pay anything. On the other hand, if the security appreciates in price, the investor receives payment on the difference between the original price and the new price. In our example, inflation or deflation of the money are the factors to consider at the end of the TRS period. 

Collateralized Debt Obligations 

Collateralized debt obligations (CDO) is a type of structured asset-backed securities that are exposed to the credit risk of a number of corporate borrowers. They are described as structured asset-backed securities because they provide cash flow to investors in an established sequence based on the assets owned. A typical structure of CDOs involves dividing the credit risks of the assets into several levels of risks; the levels with a higher credit supports the levels with lower credit risks (Frey & Backhaus, 2008). However, not all CDOs are credit derivatives; a CDO becomes a derivative only when it is used in conjunction with credit default swaps where it becomes a synthetic CDO. The main difference between CDOs and derivatives is that a derivative is a bilateral agreement in which payments occurs during specific credit events tied to the underlying asset. 

Conclusion 

Credit swap derivatives have many uses and provide flexibility to transfer and price credit risks more effectively. With increased market share and high default expectations, credit swap derivatives are said to be used more in future situations by buyers and sellers in the market to avoid cash transactions which are less efficient. Also, these credit derivatives have the ability to ensure that both the banking and financial markets become more stable. They can enhance risk management and promote diversification of risks in the financial systems. However, there are some risks that need considerations after which the use of the credit derivatives to a significant number of market participants will portray a sign of a more developed and mature market. Some of these problems are high pricing, lack of transparency and high market concentration. When these shortcomings are eliminated, the credit derivatives will be more efficient and of more benefit to the financial and banking markets. 

References 

Anderson, R.W. (2010). Credit default swaps: what are the social benefits and costs? Financial Stability Review (14), 1-14. 

Frey, R. and Backhaus, J. (2008). Pricing and Hedging of Portfolio Credit Derivatives with Interacting Default Intensities. International Journal of Theoretical and Applied Finance, 11 , ( 6), 611-634. DOI: http://dx.doi.org/10.1142/S0219024908004956 

Young, T., McCord, L. and Crawford, P. J. (2010). Credit Default Swaps: The Good, the Bad and the Ugly. Journal of Business & Economics Research 8 , (4), 29-35.