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credit derivatives

 

Credit Derivatives Definitions Guide

1.8 (Event Determination Date) | 1.14 (Calculation Agent) | 2.1 (Reference Entity) | 2.2 (Succession Event) | 2.2(e) (Succession Event Checklist) | 2.2(h) (New Credit Derivatives Transaction) | 2.3 (Reference Obligation) | 2.4 (Reference Price) | 2.14 (All Guarantee) | 2.14 (Obligations) | 2.20 (Deliverable Obligation) | 2.20(b)(i) (Not Contingent) | 2.30 (Subtitute Reference Obligation) | 4 (Credit Events) | 4.7 (Restructuring Credit Events) | 9.9 (Buy-in Procedures) |

Credit derivatives are the most commonly traded derivatives product globally. According to estimate by ISDA, the notional amount of globally traded credit derivatives was about USD35 trillion in 2007.

Credit derivatives are financial instruments which derive their value from the credit risk of reference entities, which may be corporates (e.g. Toyota) or sovereigns (e.g. Argentina). The parties to credit derivatives are called “protection buyers” and “protection sellers” and the main players are investment banks, hedge funds, insurance companies, and pension funds.

In consideration of the credit protection, the protection buyer will pay a credit protection premium (called the “fixed amount” under ISDA 2003 Credit Derivatives Definitions). If a credit event occurs during the protection period, the protection seller will pay to the protection buyer an amount equal to the loss of the protection buyer or the notional amount of the agreed obligation (where physical settlement applies).

Funded and Unfunded Credit Derivatives

Credit derivatives are commonly divided into "funded" and "unfunded" credit derivatives. Unfunded credit derivatives generally refer to bilateral principal to principal over-the-counter contract such as credit default swaps or total return swaps. Credit default swaps, or CDS, are further divided into "single name", "first to default" and constant maturity credit default swap (CMCDS, where the notional amount is reset periodically to take into account the prevailing credit spread of the reference entity).

Example of funded credit derivatives are credit-linked notes, collateralised debt obligations (CDOs), synthetic CDOs and CDO squared (CDO2). The main difference is that in a funded credit derivatives, the protection buyer does not assume the risk of the protection seller. Funded credit derivatives normally incorporate a credit default swap.

Credit Derivatives Index Trades

Credit derivatives index trades have become useful hedging tools in the last few years. Credit index such as iTraxx are index of commonly traded credit names in different regions. A credit derivatives index reduces cost of participation and increase the liquidity of the credit market and allow more market participants to enter the market.

Credit Derivatives Swaption

A swaption is a combination of a swap and an option and it is possible to enter into an option transaction (a put or a call) for a credit default swap or an index transaction.

Credit Events

The protection under the credit derivatives is triggered by one or more of the credit events such as bankruptcy, failure to pay, restructuring and repudiation/moratorium. Upon the occurrence of a credit event, the transaction will be settled by the protection seller paying the protection buyer an agreed amount. The transaction can be cash settled or physically settled.

Credit Derivatives Documentation

Credit derivatives transactions are normally entered into based on ISDA documentation using the ISDA master agreement and ISDA 2003 credit derivatives definitions. The ISDA documentation set out the treatment of important aspect of credit derivatives such as credit events, settlement (cash or physical), the type of "reference obligations" and "deliverable obligations" (e.g. bonds of the reference entities) and succession events relating to the reference entity.

In funded credit derivatives such as a credit-linked note or CDO, a special purpose vehicle will be used to issue securities such as notes to be purchased by the protection seller. The principal amount of the notes and interest payment will be adjusted by reference to the default (if any) of reference entities in the "reference pool". The SPV will enter into a credit default swap with a swap provider, normally the investment which structures the credit derivatives. Further bespoke documentation will be necessary in relation to the securities.

Credit Derivatives Articles

derivativeslawyer.com

Last updated July 2009

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The above notes are intended to highlight issues and provide only general outlines and not intended to be comprehensive nor legal advice. Where applicable, the same should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They shall never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof. If you have any question, please contact us.

The above notes are intended to highlight issues and provide only general outlines and not intended to be comprehensive nor legal advice. Where applicable, the same should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They shall never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof. If you have any question, please contact us.

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