Credit Derivative

Like their close cousins, Financial Derivatives, Credit Derivatives are instruments that derive their value from other, simpler instruments.

The value – or lack of value – of a Financial Derivative – (e.g., a Call option or a Put option – is defined soley by the value of it’s underlying instrument, and the parametric definition (i.e., strike price, time to expiration, risk free rate of interest) of the option itself.

Similarly, a Credit Derivative derives its value from another instrument. But in this case value is not derived from the market value of an underlying security, but from its credit worthiness or lack thereof.

The simplest Credit Derivative is what’s called a “Default Swap”.

Consider the case of IBM and the Investment Bank they do all of their business through – we’ll call it Big US Bank. This business might include the issuing of equity (i.e., stock) and fixed income debt, commerical paper and the borrowing of funds to smooth out fluctuations in cash flow. Big US Bank clearly does a lot of business with IBM.

Banks have internal credit limits for each customer; that is, a maximum amount of money they will lend to that customer. This is true not only for Corporate clients, but – as most of us no doubt know - in the retail universe as well. No matter how much money you earn, your Master Card definitely has a limit. And even American Express will ask carefully ask you questions should you attempt to charge, for example, a $20 million vacation on Mir.

Credit limits make a lot of sense; it is better for banks to lend relatively small amounts of capital to a large number of counterparties, rather than large amounts of money to a small number of counterparties. All other things being equal, the odds of a large number of borrowers simultaneously defaulting on their obligations are much smaller. In finance this is called the Theory of Large Numbers.

But Corporate customers can generate such massive volumes of business that their borrowing demands can rapidly drive through the internal lending limits of even the largest Investment Bank.

The banks quandary is easily understood thus; the Corporate customer – IBM - wants to borrow additional funds but if such a loan is granted Big US Bank will have far too much capital lent out to a single counterparty.

On the other hand, Big US Bank dare not to displease IBM, who may opt to take all of their business to another bank who will make the loan. Until recently large corporations could use this threat to their advantage, forcing banks to make loans that would put them on shakey ground financially. Not surprising, this led to failures of some of the weaker institutions from time to time.

Starting the mid 1990’s Financial Engineers came up with a solution – the Credit Default Swap. It works like this :

Assume that Big US Bank simply must issue a new loan to IBM. But such a loan will drive through the internal credit limit that Big US Bank has established for IBM; that maximum amount of money they will lend to this counterparty.

So Big US Bank goes ahead and makes the loan, but simultaneously purchases a Credit Default Swap, typically from another Investment Bank, for example, Big Foreign Bank.

Big Foreign Bank will make Big US Bank "whole” should IBM default. That is, if the IBM misses a payment, enters into bankruptcy, etc, Big Foreign Bank will insure that no money is lost by Big US Bank.

You might think that this is nothing more than an insurance policy, and you would be correct. But what is being insured is a loan from an Investment Bank to a corporate client unlike, for example, someone’s life or a piece of property.

Credit Derivatives are an example of what are called Over the Counter, or OTC instruments due to the high degree of specialisation that goes into their construction. The terms of default might include not only missing a payment, but a downgrade in credit rating, business falling below a certain threshold, and pretty much any other items that could impact business.

Less than six years old, the market for Credit Derivatives has recently passed the $50 billion dollar per year mark. Many market participants believe that it will ultimately surpass the size of the market for Financial Derivatives – roughly some $26 trillion dollars per annum.

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