Understand credit derivatives for the exam. Learn about Credit Default Swaps (CDS), credit indices, and how institutions use them for credit risk management.
Credit Derivatives Overview
Credit derivatives allow transfer of credit risk without transferring the underlying asset. They're essential tools for institutional risk management.
Credit Default Swaps (CDS)
How CDS Works
- Protection buyer pays periodic premium
- Protection seller pays if credit event occurs
- Reference entity: company whose credit is transferred
- Notional amount: face value of protection
Credit Events
- Bankruptcy
- Failure to pay
- Restructuring
- Defined in ISDA documentation
Settlement
- Physical: Buyer delivers defaulted bonds, receives par
- Cash: Seller pays par minus recovery value
- Auction process determines recovery
CDS Pricing
- Spread quoted in basis points
- Higher spread = higher perceived credit risk
- Related to bond credit spreads
- Affected by liquidity and market conditions
Credit Indices
CDX and iTraxx
- Baskets of single-name CDS
- CDX: North American credits
- iTraxx: European credits
- Investment grade and high yield versions
- Standardized, more liquid than single-name
Uses of Credit Derivatives
- Hedging: Protect against default of bond holdings
- Speculation: Express view on credit quality
- Arbitrage: Exploit pricing differences
- Synthetic exposure: Gain credit exposure without buying bonds
Risks and Considerations
- Counterparty risk
- Basis risk vs. cash bonds
- Liquidity risk
- Documentation complexity
Key Exam Topics
- CDS mechanics and terminology
- Credit events and settlement
- Uses of credit derivatives
- Credit index products
- Risk considerations
Tags:credit derivativesCDScredit default swap