Set out what credit derivatives are and their main features
The idea
A credit derivative transfers the credit risk of a reference entity from one party to another without transferring the underlying debt. The main example is the credit default swap. The protection buyer pays a periodic premium, the CDS spread, to the protection seller; if a credit event occurs, such as bankruptcy, failure to pay or a qualifying restructuring, the seller compensates the buyer for the loss, by physical or cash settlement. A rating downgrade alone is not a credit event. The protection buyer is short credit risk and the seller is long it, much like a bondholder. Single-name CDS reference one issuer, while index CDS cover a portfolio of names and are used to hedge or take broad credit exposure. If the reference entity's credit quality worsens, spreads widen and an existing protection buyer's position gains value. Lenders use CDS to hedge loans they wish to keep on the balance sheet.
Formulas
Credit default swap cash flows
P = s × N and Q = N × (1 − R)
- P
- the yearly premium paid by the protection buyer
- s
- the spread, quoted in basis points
- N
- the notional, the face value protected
- Q
- the payment by the protection seller on a credit event
- R
- the recovery rate
The buyer pays the premium until a credit event; the seller then pays the loss given default.
A practice question
In a credit default swap, the protection buyer:
- pays a periodic premium to the seller - correct
- receives a periodic premium from the sellerWhy not: Reverses the roles; the seller is paid for bearing the credit risk.
- must own the reference entity's bondsWhy not: A CDS can be bought without holding the underlying debt.
The buyer pays the CDS spread and in return is compensated by the seller if a credit event occurs on the reference entity.
A harder one
An investor wants to hedge broad exposure to investment-grade corporate credit rather than to one issuer. The most suitable instrument is:
- an index credit default swap - correct
- a single-name credit default swapWhy not: Covers only one reference entity, not the broad market the investor holds.
- a receive-fixed interest rate swapWhy not: Changes interest rate exposure and leaves credit risk unhedged.
An index CDS references a portfolio of issuers, so one contract hedges or takes exposure to credit risk across the market segment.
The hardest tier
A bank wants to keep a large loan on its balance sheet while hedging the borrower's default risk. It should:
- sell CDS protection on the borrowerWhy not: Selling protection adds to the same credit exposure the bank wants to hedge.
- enter a pay-fixed interest rate swapWhy not: Hedges interest rate risk and does nothing about the borrower's default.
- buy CDS protection on the borrower - correct
Buying protection transfers the default risk to the seller: if the borrower defaults, the CDS payment offsets the loss on the loan, which the bank still holds.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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