Credit Derivatives (CDs)

Introduction to Credit Derivatives (CDs):

• Credit derivatives are financial instruments that allow investors to manage or transfer credit risk.
• They are contracts whose value is derived from the credit performance of an underlying asset, typically a bond, loan, or reference entity.

Types of Credit Derivatives:

1. Credit Default Swap (CDS):
   • CDS is the most common type of credit derivative.
   • It provides insurance against the default of a particular borrower (reference entity) by making regular premium payments.
2. Credit Linked Note (CLN):
   • CLN is a debt instrument whose payments are linked to the credit performance of an underlying reference entity.
3. Total Return Swap (TRS):
   • TRS allows the transfer of both credit risk and market risk associated with an underlying asset, often a bond or loan.
4. Collateralized Debt Obligation (CDO):
   • CDOs pool various debt securities, often with different levels of credit quality, and issue different tranches to investors with varying risk and return profiles.

Functions of Credit Derivatives:

1. Risk Transfer:
   • Credit derivatives allow financial institutions to transfer credit risk to other parties, enhancing risk management.
2. Risk Management:
   • Investors can use credit derivatives to hedge against credit losses, ensuring more stable portfolios.
3. Liquidity Enhancement:
   • Credit derivatives provide an additional market for trading credit risk, increasing market liquidity.

Credit Default Swap (CDS):

• CDS is a contract between a protection buyer and a protection seller.
• The protection buyer pays regular premiums to the seller in exchange for a promise to compensate in case of default by the reference entity.

CDS Parties:

• Protection Buyer: Pays premiums and receives compensation in case of default.
• Protection Seller: Receives premiums and pays compensation in case of default.
• Reference Entity: The entity whose default triggers the CDS.

CDS Trigger Events:

• Credit Event: This includes default, bankruptcy, and restructuring of the reference entity.
• Physical Settlement: Involves delivering the actual defaulted debt securities.
• Cash Settlement: Involves paying the difference between the face value of the debt and its market value.

Multiple Choice Questions (MCQs) with Answers:

1. What is the primary purpose of credit derivatives? a) To speculate on interest rate changes b) To manage credit risk and transfer it c) To maximize portfolio returns d) To eliminate all forms of financial risk Answer: b) To manage credit risk and transfer it
2. Which type of credit derivative is used to insure against the default of a particular borrower? a) Credit Linked Note (CLN) b) Total Return Swap (TRS) c) Collateralized Debt Obligation (CDO) d) Credit Default Swap (CDS) Answer: d) Credit Default Swap (CDS)
3. What is the role of a protection seller in a CDS contract? a) Pays premiums and receives compensation in case of default b) Receives premiums and pays compensation in case of default c) Holds the underlying reference entity d) Manages the underlying asset portfolio Answer: b) Receives premiums and pays compensation in case of default
4. What is the primary trigger for a Credit Default Swap (CDS)? a) Interest rate changes b) Stock market volatility c) Credit event such as default or bankruptcy d) Currency exchange rate fluctuations Answer: c) Credit event such as default or bankruptcy
5. Which function do credit derivatives serve that enhances market liquidity? a) Speculation on market trends b) Mitigation of currency risk c) Transfer of credit risk d) Elimination of interest rate risk Answer: c) Transfer of credit risk