Credit derivative

In this paper we will find that credit derivatives intends to transfer the credit risks by minimizing the credit exposures. Credit derivatives may take three different forms, namely, Credit Default Swap, Credit Linked Note and Total Return Swap. This will be explained below in detail.
A credit derivative is basically an Over the Counter derivative, which is designed for transferring the credit risks from one credit holder to another. Moreover, the credit derivatives help the credit institutions to manage the credit risks efficiently by reducing credit exposures.

Most of the credit derivatives face the credit exposures from two sources: reference asset and defaults made by the counter party at the time of transaction.

Categorization:
Credit derivatives are of three forms: Credit Default Swap (CDS), Credit Linked Note and Total Return Swap (TRS). These are discussed below.

In case of a credit default swap, two parties file an agreement according to which, one party pays a fixed periodic interest, which is referred as Coupon, to the other throughout the agreement period while, the other party pays no interest unless a specified credit event, like, bankruptcy, debt restructuring, material default etc, takes place.
A credit-linked note is basically a debt instrument, which is related with credit derivative.

In case of total return swap, two parties make an agreement, like credit default swap, whereby the periodic interest will be paid alternately, that is, they will swap the payment intermittently. The two parties will make the payment based on two different facts, namely, vanilla interest rate swap and capital gains or losses on a “reference asset”. In addition to that, both the parties’ payment depends upon the same “notional amount”.
Difference Between a CDS and TRS:
A credit default swap protects the credit institutions from any credit event while; a total return swap combats loss of value, no matter what the causes are.

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Last Updated on : 1st August 2013