Credit Derivatives

Overview of Credit Derivatives and Implementation in FinCAD and Bloomberg

March 15th 2006

Table of Contents

1. Introduction to Credit Derivatives вЂ¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦3

2. Types of Credit Derivatives вЂ¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦6

3. Using FinCAD to price Credit Derivatives вЂ¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦..10

4. Using Bloomberg to price Credit Derivatives

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5. References

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Introduction to Credit Derivatives

What are Credit Derivatives?

Definition: A credit derivative is a derivative security that is primarily used to transfer, hedge or manage credit risk. Its payoff is materially affected by credit risk.

Credit derivatives are financial contracts that allow the transfer of credit risk from one market participant to another, potentially facilitating greater efficiency in the pricing and distribution of credit risk among financial market participants. Formally, credit derivatives are bilateral financial contracts that isolate specific aspects of credit risk from an underlying instrument and transfer that risk between two parties. In so doing, credit derivatives separate the ownership and management of credit risk from other qualitative and quantitative aspects of ownership of financial assets.

The need and advantages of credit derivatives

1. Until recently, credit remained one of the major components of business risk for which no tailored risk-management products existed

2. Without credit derivatives, credit risk management was inefficient primarily because they do not separate the management of credit risk from the asset with which that risk is associated. For example, these strategies would either mean purchasing insurance on the credit risk exposure or simply carry the open exposure on the portfolio.

3. The Reference Entity, whose credit risk is being transferred, need neither be party to nor aware of a credit derivative transaction. This confidentiality enables banks and corporate treasurers to manage their credit risks discreetly without interfering with important customer relationships

4. Credit derivatives are the first mechanism via which short sales of credit instruments can be executed with any reasonable liquidity and without the risk of a short squeeze. The alternative for banks would have to short sell their loan which is more or less impossible.

5. Credit derivatives, except when embedded in structured notes, are off-balance sheet instruments. The appeal of off- as opposed to on-balance-sheet exposure will differ by institution:

6. The more costly the balance sheet, the greater the appeal of an off-balance-sheet alternative.

The growth of the Credit Derivatives Market

The credit derivatives market is hugely popular and this is borne out by the growth in this market which is shown in the chart below

The exhibit below illustrates who uses credit derivatives and for what purpose.

Risks and Challenges

In the reference [3], the author has summarized some of the challenges and risks faced by the participants in the Credit Derivatives market.

“Growth of the market is tempered by risks and notable challenges, some of which were highlighted in a 2005 survey of credit derivatives market participants conducted by Fitch Ratings. According to Fitch, the top 10 global banks and broker/dealers hold 70 percent of the total gross sold positions. Consequently, should one of these major market makers falter, there could be a disruption in market liquidity.

In addition, Fitch pointed out that because similar models and risk management assumptions are used among banks and broker/dealers, that could spell trouble for the already taxed infrastructure in place should a sell signal trigger a mass exodus from one market. Analysts universally note that in order to facilitate future growth, additional resources will need to be directed into technology systems to directly support the entire lifecycle of credit derivatives.”

Types of Credit Derivative Products

The chart below gives a categorization of the various