Credit Derivative

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table3"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table4"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table5"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Credit Derivative</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table6"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#Credit Default Swap">credit default swap</a><p class="word_list"> <a href="#credit derivative">credit derivative</a><p class="word_list"> <a href="#Credit Linked Note">credit linked note</a><p class="word_list"> <a href="#Total Return Swap">total return swap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table7"> <tr> <td width="300" height="14"><font size="2"> </font><font size="4"> </font></td> <td width="9" height="14"></td> </tr> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">A <b><a name="credit derivative">credit derivative</a></b> is an <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivative</a> designed to transfer <a href="../articles/credit_risk.htm">credit risk</a> from one party to another. By synthetically creating or eliminating <a href="../articles/credit_risk.htm">credit exposures</a>, they allow institutions to more effectively manage credit risks. Credit derivatives take many forms. Three basic structures include: </p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="Credit Default Swap">credit default swap</a>:</b> Two parties enter into an agreement whereby one party pays the other a fixed periodic <a href="../articles/coupon_bond.htm">coupon</a> for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's <a href="../articles/valuation.htm">market value</a> following the credit event. <p class="bullet_line_space" style="margin-top: 12; margin-bottom: 12"> <img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="Total Return Swap">total return swap</a>:</b> Two parties enter an agreement whereby they swap periodic payment over the specified life of the agreement. One party makes payments based upon the <a href="../articles/return.htm">total return</a>—coupons plus capital gains or losses—of a specified reference asset. The other makes fixed or floating payments as with a vanilla interest rate swap. Both parties' payments are based upon the same <a href="../articles/notional_amount.htm">notional amount</a>. The reference asset can be almost any asset, index or basket of assets. <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9" height="14"></td> <td width="336" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="Credit Linked Note">credit linked note</a>:</b> A debt instrument is bundled with an embedded credit derivative. In exchange for a higher <a href="../articles/yield.htm">yield</a> on the note, investors accept exposure to a specified credit event. For example, a note might provide for <a href="../articles/par_value.htm">principal</a> repayment to be reduced below <a href="../articles/par_value.htm">par</a> in the event that a reference asset defaults prior to the maturity of the note. <p class="body">The fundamental difference between a credit default swap and a total return swap is the fact that the credit default swap provides protection against specific credit events. The total return swap provides protection against loss of value irrespective of cause—a default, market sentiment causing credit spreads to widen, etc. </p> <p class="body">Most credit derivatives entail two sources of credit exposure: one from the reference asset and the other from possible default by the counterparty to the transaction. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table9"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%"> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/asset_value_model.htm">asset value model</a> A model for assessing the credit risk of corporate debt.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><span class="verdana10"><a href="../articles/collateral.htm"><strong style="font-weight: 400">collateral</strong></a></span><strong style="FONT-WEIGHT: 400"> Assets held to secure an obligation.</strong><p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_debt_obligation.htm">collateralized debt obligation</a> A securitized interest in debt.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><span class="verdana10"><strong style="font-weight: 400"><a href="../articles/credit_enhancement.htm">credit enhancement</a></strong></span><strong style="FONT-WEIGHT: 400"> Any methodology that reduces the credit risk of a transaction with a counterparty.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_risk.htm">credit risk</a> Risk due to uncertainty in a counterparty's ability to perform on an obligation.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/equity_default_swap.htm">equity default swap</a> A far out-of-the-money equity option structured much like a credit default swap.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table11"> <tr> <td width="100%"> <p class="explanatory_text">Bomfim (<a target="_blank" href="http://www.riskbook.com/link/bomfim_antulio_(2005).htm">2005</a>) is the essential introduction to credit derivatives. Gregory (<a target="_blank" href="http://www.riskbook.com/link/gregory_j_(2003).htm">2003</a>) is a more advanced book. See Das (<a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2005).htm">2005</a>) for an exhaustive treatment of instruments and conventions. For credit derivatives pricing, Schonbucher (<a target="_blank" href="http://www.riskbook.com/link/schonbucher_p_(2003).htm">2003</a>) is the bible.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap640"> <area target="_blank" href="http://www.riskbook.com/link/bomfim_antulio_(2005).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_bomfim_antulio_(2005)_125.gif" usemap="#FPMap640" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/bomfim_antulio_(2005).htm"> Understanding Credit Derivatives</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Antulio N. Bomfim</b></td> </tr> <tr> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <td width="10%"><map name="FPMap568"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_6.gif" usemap="#FPMap568" width="90" height="16"></td> </span> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <td width="10%"> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <map name="FPMap569"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15"> </map> <img border="0" src="../images/tech_3.gif" usemap="#FPMap569" width="90" height="16"></span></td> </span> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2005</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap639"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/bomfim_antulio_(2005).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap639" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap637"> <area target="_blank" href="http://www.riskbook.com/link/gregory_j_(2003).htm" shape="rect" coords="0, 0, 80, 124"> </map> <img border="0" src="../images/book_gregory_j_(2003)_125.gif" usemap="#FPMap637" width="81" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/gregory_j_(2003).htm"> Credit Derivatives<br> <font size="2">The Definitive Guide</font></a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Jon Gregory (Editor)</b></td> </tr> <tr> <span style="font-family: Times New Roman; 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