Introducing Credit Derivatives

Recent economic turmoil has generated considerable discussion about the nature of credit derivatives and their effect on how the market is perceived.

But has the late arrival and subsequent breathtaking development of the credit derivative just been poorly understood? If the well-established equity and insurance markets had developed in similar circumstances, would they too have been treated with equal suspicion?

The supposedly high risks associated with credit derivatives are not supported by research. A 2004 academic survey conducted by the International Swaps and Derivatives Association (ISDA) of 84 professors from the top 50 business schools found that 99% thought that the impact of derivatives on the global financial system was beneficial, with 81% agreeing that the risks of using derivatives had been overstated.

WHAT IS A CREDIT DERIVATIVE?

Credit derivatives isolate credit risk from other risks present in an asset.

SG Warburg arranged the first Eurobond in 1963: a $15m, ten to 15-year bond issued by Italian Autostrada.

The bondholders took on the currency risk that the exchange rate of the dollar would collapse against domestic currencies. As the bonds were fixed-rate, they also assumed interest rate risk: if USD-LIBOR interest rates rose above the fixed interest rate of the Autostrada bonds, then a bond holder would suffer this exposure (the yield of the bonds would be low in comparison to other investments).

Investors also took the risk that both the tenor of the securities and their maturity could prove illiquid.

Finally, investors were taking a risk on Autostrada’s creditworthiness, namely the risk that Autostrada could become bankrupt, default on the payment of interest or repayment of principal, that the company could repudiate the debt or declare a moratorium or that the company could restructure the bond leading to a material decline in the company’s creditworthiness.

Those investors that wished only to assume and invest in the credit risk of Autostrada were forced to assume all of the other risks related to its obligations, such as currency risk, liquidity risk, interest rate risk, maturity risk and all other risks inherent in any capital markets security. This was norm for all bond and loan market investors until the invention of credit derivatives in the 1990s.

RISK BALANCE

All derivatives derive their value from an underlying asset. In the case of credit derivatives, the underlying asset is the credit risk of an underlying reference entity, be it corporate, sovereign or a similar organisation.

Credit derivatives aim to isolate the credit risk of a reference entity (the issuer of a bond) from the other risks inherent in its obligations. Credit risk can then be separately traded.

Using the example of Italian Autostrada, imagine that credit derivatives had been invented 30 years earlier, in 1963. An investor entering into a credit derivative transaction referencing Italian Autostrada could have sold credit protection to gain exposure to Autostrada’s credit risk instead of buying Eurobonds containing the rest of the bundle of risks.

Instead of the investor taking on a portion of the Eurobond’s interest rate corresponding to credit risk, the investor’s derivatives counterparty would be paying a premium in return for it assuming the same credit risk.

Bilateral derivatives contracts require counterparties to take opposite views. That the investor’s counterparty might chose to purchase a corresponding amount of Eurobonds to gain exposure to the other risks comprising the bundle of risks, while buying protection against Italian Autostrada’s credit risk.

This investor would have assumed currency risk, interest rate risk, liquidity risk and market risk, but would have been protected against the credit risk in return for it paying a premium.

The Italian Autostrada Eurobond also preceded the interest rate and currency rate derivatives markets which developed in the 1960s and 1970s, but had these markets existed, an Italian Autostrada bondholder could have hedged itself against currency movements with a currency swap or against interest rate movements with an interest rate swap.

The credit derivative, like currency derivatives and interest rate derivatives, allow particular risks to be isolated and separately traded. Credit risk can never be entirely isolated from other risks, but the credit derivative product allows other risks to be minimised.

More complex credit derivatives repackage and redistribute the credit risk of a portfolio of different assets among different investors in accordance with their appetite for risk.