The Role of Credit Derivatives in Finance

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In the world of business it is important to keep the level of financial risk low, whether it is in connection with investments or other financial assets. Moreso, when it comes to credit arrangements in which a seller is keen on covering his financial interests from credit risk.
In such cases, a bilateral contract is drawn between buyer and seller which pertains to protection from undesirable events such as failure to pay by the buyer. In the credit derivatives markets, there is considerable involvement of banks, hedge funds, pension funds and insurance companies among others.

And some of the most common credit default products are credit default swaps (unfunded), and collaterized debt obligations (funded). Funded derivatives relate to instances where credit protection is actually bought and sold, essentially this is achieved through the use of securitization techniques.

For those purchasing these types of credit products, do so based on the credit rating allocated by rating agencies on a given credit transaction in terms of risk. Unfunded credit derivatives principally involve a bilateral contract, it serves to put under obligation both sides for them to hold their end of the bargain (via payments).

This is done on the understanding that the parties will stick to the agreed remittances without the need to seek redress through other assets.

There are many forms of unfunded credit derivative products and they include credit spread options, total return swap, CDS index products, recovery lock transaction, and secured loan credit default swap among others.

While some products such as the credit linked note (CLN), synthetic constant proportion, portfolio insurance (synthetic CPPI), synthetic collaterized debt obligation and the constant proportion debt obligation (CPDO) are examples of funded credit derivative products.

Typically, credit agreements can only be settled on the occurrence of verifiable events like defaulting on an obligation, restructuring of an obligation or moratorium and declared bankruptcy. This means that the credit protection buyer can proceed with the onward transmission of the defaulted obligations to the protection seller.

The credit linked note (CLN) incorporates a regular note with a credit default swap, and as such it is used by investors to canvass against losses due to loan defaults. Hence, the cash flow of credit linked note relies on any changes relating to a credit spread, or rating change but the events are not limited to only these kinds of changes, but rather are based on agreed conditions by the parties involved in the credit derivative deal.

Collateral debt obligations allow for the use of a single instrument covering various companies to be made available in tranches (slices), with bonds and loans as their underlying risks.
 

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