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Trading and Capital-Markets Activities Manual

Instrument Profiles: Credit Derivatives
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


Credit derivatives are off-balance-sheet financial instruments that permit one party (the beneficiary) to transfer the credit risk of a reference asset, which it typically owns, to another party (the guarantor) without actually selling the asset. In other words, credit derivatives allow users to ''unbundle'' credit risk from financial instruments and trade it separately. 

Based on dealer estimates, the market for credit derivatives approached $40 billion in 1996, with total-return swaps and default puts (including default swaps and outright put options) accounting for more than half of the market. The average transaction size is rather small at $10 million to $25 million, while the average tenor of transactions is less than two years. The tenor of new transactions is lengthening, however, and swaps up to five years are not uncommon. While the slowly expanding market for credit derivatives has encouraged dealers and end-users to enter the market, secondary-market activity is very limited. 


In general, credit derivatives have three distinguishing features: 

1. the transfer of the credit risk associated with a reference asset through contingent payments based on events of default and, usually, the prices of instruments before, at, and shortly after default (reference assets are most often traded sovereign and corporate debt instruments or syndicated bank loans) 
2. the periodic exchange of payments or the payment of a premium rather than the payment of fees customary with other off-balance-sheet credit products, such as letters of credit 
3. the use of an International Swap Derivatives Association (ISDA) master agreement and the legal format of a derivatives contract 

Credit derivatives fall into three basic transaction types: total-rate-of-return swaps, credit default swaps, and credit-default notes. Presently, total-rate-of-return swaps are the most commonly used credit derivatives.

Total-Rate-of-Return Swaps 

In a total-rate-of-return (TROR) swap, one counterparty (Bank A) agrees to pay the total return on an underlying reference asset to its counterparty (Bank B) in exchange for LIBOR plus a spread. Most often, the reference asset is a corporate or sovereign bond or a traded commercial loan. Since many commercial loans are based on the prime rate, both ''legs'' of the swap float with market rates. In this manner, credit risk is essentially isolated and potential interest-rate risk is generally limited to some form of basis risk (for example, prime vs. LIBOR). 

TROR swaps are intended to be an efficient means of transferring or acquiring credit exposure without actually consummating a cash transaction. This feature may be desirable if a bank (Bank A) has credit exposure to a borrower which it would like to reduce while retaining the borrower as a customer, preserving the banking relationship. Also, entities which are not able to bear the administrative costs of purchasing or administering loans, or loan participations, may still acquire exposure to these loans through TROR swaps (Bank B). 

In the example in figure 1, Bank A receives a LIBOR-based payment in exchange for paying out the return on an underlying asset. The total return payments due to Bank B include not only the contractual cash flows on the underlying assets, but also any appreciation or depreciation of that underlying asset that occurs over the life of the swap. Periodically (usually quarterly), the asset's market price is determined by an agreed upon mechanism. Bank B would pay Bank A for any depreciation in the value of the 

Figure 1-Total-Rate-of-Return Swap

underlying asset while receiving any appreciation. Consequently, for the term of the swap, it is as if Bank B actually owns the reference asset that resides on Bank A's balance sheet. 

At the maturity of the swap, or in the event of default of the underlying asset, the swap is terminated1 and the underlying asset is priced for purposes of determining the final swap obligations. The post-default price of the asset is most often determined by a poll of asset dealers or by direct market quotation, if available. Often, the final price will be the average of sample prices taken over time to mitigate any post-default volatility in the reference asset's value. 

If Bank B is not satisfied with the pricing of the asset upon maturity of the swap or default (that is, believes the valuation is too low), then Bank B will often have the option of purchasing the underlying reference asset directly from Bank A and pursuing a workout with the borrower directly. However, it is not clear how often Bank B would choose to purchase the underlying instrument, particularly if the swap vehicle were used to avoid direct acquisition in the first place. 

The final termination payment is usually based on the following formula: 

Final Payment = Dealer Price - Notional Amount 

The notional amount is essentially the price of the reference asset when the credit derivative is initiated. If the dealer price is greater than the notional amount, then the asset has appreciated and Bank A must pay Bank B this difference to settle the swap. On the other hand, if the dealer price is below the notional amount, either depreciation (for example, downgrade or default) or principal reduction (for example, amortization, prepayment) has occurred, and Bank B owes Bank A this difference. Therefore, the final payment (either at maturity or upon default) ultimately defines the nature and extent of the transfer of credit risk. 

Default events are described in the transaction documentation, usually the trade confirmation. These events may include bankruptcy, payment defaults, breached covenants in loan or bond documentation, or even the granting of significant security interests by the reference obligor to one of its creditors. Often, a default event is defined so as to apply to any class of outstanding securities of the reference obligor in excess of a specified amount. In other words, a default can be triggered if the reference asset defaults or if any material class of securities issued by the underlying obligor defaults. 

In an alternative structure, two banks may exchange the total return on underlying groups of loans. For example, a large money-center bank may receive the total return on a concentrated loan portfolio of a regional bank in exchange for the total return on a more diversified group of loans held by the money-center bank. These types of swaps may be readily marketable to smaller banks that are seeking to comply with the concentration of credit limitations of section 305(b) of the Federal Deposit Insurance Corporation Improvement Act (FDICIA). 

1. Alternatively, the swap may continue to maturity with payments based on quarterly changes in the post-default asset price. 

Credit-Default Swaps 

In a credit-default swap, one counterparty (Bank A) agrees to make payments of X basis points of notional amount, either per quarter or per year, in return for a payment in the event of the default of a pre-specified reference asset (or name). (See figure 2.) Since the payoff of a credit-default swap is contingent on a default event (which may include bankruptcy, insolvency, delinquency, or a credit-rating downgrade), calling the structure a ''swap'' may be a misnomer; the transaction more closely resembles an option. 

As with TROR swaps, the occurrence of default in credit-default swaps is contractually well defined. Usually, the default event must be publicly verifiable. The default definition must be specific enough to exclude events whose 

Figure 2-Credit-Default Swap

inclusion would be undesirable, such as when a reference name is delinquent due to the intentional withholding of a payment in a legal dispute that does not affect the creditworthiness of the organization. Further, a materiality threshold may be involved; that is, a default event must have occurred, and the cumulative loss on the underlying must be greater than Y percent. The materiality thresholds increase the likelihood that only significant changes in credit quality will trigger the default payment (rather than small fluctuations in value that tend to occur over time). 

Finally, upon default, the ''swap'' is terminated and a default payment is calculated. The default payment is often calculated by sampling dealer quotes or observable market prices over some pre-specified period after default has occurred. Alternatively, the default payment may be specified in advance as a set percentage of notional (for example, 25, 50, or 100 percent). Such swaps are usually referred to as binary swaps; they either pay the pre-specified amount or nothing, depending on whether default occurs. Binary swaps are often used when the reference asset is not liquid but when loss in the event of default is otherwise subject to estimation. For example, if the reference asset is a senior, unsecured commercial bank loan, and such loans have historically recovered 80 percent of face value in the event of default, a binary default swap with a 20 percent contingent payout may be appropriate. 

When the counterparty making the default payment (guarantor) is unhappy with the valuation, the option to purchase the reference asset is often available. On the other hand, some versions of default swaps may allow the beneficiary to put the asset to the guarantor in the event of default rather than receive a cash payment. Finally, when there is more than one underlying instrument (or name), which is often found in a ''basket'' structure, the counterparty making the contingent default payment is exposed to only the first instrument or name to default. 

Credit-Default Notes 

A credit-default note is a structural note and is the on-balance-sheet equivalent of a creditdefault swap. In a credit-default note, an investor purchases a note from an issuing vehicle, 

Figure 3-Credit-Default Note

often a trust. The proceeds of the note purchase are used by the trust to purchase paper of the highest credit quality: Treasuries, agencies, or AAA corporate paper. The note is structured such that a default by the underlying reference instrument(s) or name(s) results in a reduction of the repayment of principal to the investor. Default payments are calculated in the same manner as for TROR and credit-default swaps. In return for the contingent default payment, the arranging bank pays a spread to the investor through the issuing vehicle. The investor, meanwhile, receives a premium yield over LIBOR for accepting the default risk of the underlying instrument(s) or name(s). (See figure 3.) 


Both total rate-of-return swaps and credit-default swaps are used to transfer the credit risk of the asset(s) referenced in the transaction. The counterparty seeking to transfer the credit risk (the beneficiary) often owns the reference asset. The counterparty receiving the credit risk of the reference asset (the guarantor) is able to do so without purchasing the reference asset directly. 

Banks may use credit derivatives in several ways. They may elect to receive credit exposure (provide protection) for a fee or in exchange for credit exposure which they already hold in an effort to better diversify their credit portfolios. 

Banks may also elect to receive credit exposure through credit derivatives rather than through some other transaction structure due to the relative yield advantage (arbitrage of cash-market pricing) of derivatives. 

Alternatively, banks may use credit derivatives to reduce either individual credit exposures or credit concentrations in their portfolios. In other words, the banks are purchasing credit protection from another institution. Banks may use credit derivatives to synthetically take a short position in an asset which they do not wish to sell outright. From the bank customer's perspective, credit derivatives may be written to allow non-bank counterparties to obtain access to bank loan exposures and related returns either as a new asset class (for credit diversification) or without up-front funding (perhaps to obtain greater leverage). In the last example, the bank is essentially performing traditional credit intermediation using a new off-balance-sheet vehicle. 

Finally, banks may seek to establish themselves as dealers in credit derivatives. Rather than pursuing credit portfolio efficiency or portfolio yield enhancement, dealer banks will seek to profit from buying and selling credit derivatives exposures quite apart from their portfolio management goals. Dealer banks may or may not hold the assets referenced in their credit-derivative transactions, depending on their risk tolerance, credit views, and (ultimately) their ability to offset contracts in the marketplace. 


Issuing Practices 

Credit derivatives are transacted by banks, securities firms, and insurance companies through financial contracts traded over the counter. The size of the marketplace is fairly small, with up to 15 organizations actively transacting in credit derivatives by year-end 1996. Due to the small size and name-specific nature of the credit-derivative market, there is very little secondary-market support. 

Market Participants 

Commercial and investment banks, insurance companies, and hedge funds are active as both buyers and sellers of credit derivatives. Pension funds and money managers have also acted as counterparties to credit-derivative transactions. 

Market Transparency 

Currently, there is no market transparency in the pricing or volume of credit derivatives. Most transactions are highly structured, negotiated deals between sophisticated counterparties. One money-center bank has made price quotes publicly available for several transactions structures that reference the obligors most often found in current transactions or in whom there is the most interest at the time. However, pricing transparency is poor. Further, regulatory and public reporting standards for credit derivatives have not yet been established. Consequently, the level of business activity is also not readily transparent. The estimates of the market size and composition available to date are the result of surveys conducted by credit-derivatives dealer banks (for example, CIBC/Wood-Gundy) or industry groups (for example, the British Bankers' Association). At year-end 1996, the market for credit derivatives was estimated to be $40 billion. 


To understand credit-derivative pricing and how different prices for reference assets might be obtained for different counterparties, consider the following example. A bank offers to provide default protection to another bank on a five-year loan to a BBB-rated borrower. Since reliable default and recovery data for pricing credit derivatives are not available, credit-derivatives providers rely on credit spreads to price these products. One of the more common pricing techniques is to price an asset swap of the reference asset. In an asset swap, a fixed-for-floating interest-rate swap is used to convert a fixed-rate instrument (here, a BBB-rated note) into a floating-rate instrument. The spread above LIBOR required for this conversion to take place is related to the creditworthiness of the reference borrower. That is, the lower the creditworthiness of the reference borrower, the greater the spread above LIBOR to complete the asset swap. Hence, if LIBOR is viewed as a base rate at which the most creditworthy institutions can fund themselves, then the spread above LIBOR represents the ''credit premium,'' or the cost of default risk, associated with that particular reference asset. 

The credit premium is the most fundamental component of pricing. The credit premium is meant to capture the default risk of the reference asset. Often, the credit premium is the periodic payment rate required by market participants in exchange for providing default protection. In a total-return swap, LIBOR plus this credit premium is paid in exchange for receiving the total return on the underlying reference asset. Intuitively, the owner of the reference asset, who receives LIBOR plus the credit premium, is being compensated for funding costs and default risk of the reference asset. 

Furthermore, assume the reference asset is a BBB-rated, senior unsecured note of five-year maturity yielding 6.50 percent. Further, assume that the asking price for a five-year, fixed-for-floating interest-rate swap is 6.03 percent against LIBOR flat. To complete the asset swap, the interest-rate swap legs need to be increased by 47 basis points each to convert the reference asset to a floating-rate instrument. (See figure 4.) Consequently, 47 basis points is the credit premium, or the implied market price to be charged, per year, for providing default protection on this BBB-rated reference asset. Alternatively, LIBOR plus 47 basis points would be the price to be paid in a TROR swap for receiving the total return on this asset for five years. 

However, the borrower-specific factors that produced the implied market price of 47 basis points for the default swap are not the only factors considered in pricing. The spread may be adjusted for any number of factors which are unique to the counterparties. For example, the spread may need to be adjusted for counterparty 

Figure 4-Asset Swap

credit considerations. In the example in figure 2, if the credit quality of the guarantor counterparty (Bank B) was a concern to the beneficiary (Bank A), the beneficiary might negotiate payment of a lower spread (fee) than 47 basis points to compensate for counterparty risk. 

Often, differences in funding costs between counterparties also affect pricing. A counterparty that could obtain credit exposure through direct acquisition of the asset on a favorable basis due to funding advantages might require a higher return for taking on the same exposure through a default swap, which is priced by analogy to an asset swap. Operational considerations, such as the inability of a guarantor counterparty to actually own the asset, may result in a pricing premium for the risk seller (protection buyer) who can own the asset. Similarly, tax consequences may have an impact on transaction pricing. For example, a beneficiary may wish to reduce credit exposure to an obligor without actually selling the reference asset to avoid triggering an unfavorable taxable event, such as a taxable gain or a capital loss that is not fully deductible. Clearly, these considerations may have an impact on the price which the protection buyer (risk seller) is willing to pay. 

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