Understanding Credit Derivatives

Truly understanding credit derivatives and the way they function can be the work of a lifetime for a banker, trader, or investor. However, it is possible to gain a basic understanding of the function of these financial instruments and their role in the global financial system. It helps to understand one thing about credit first: By lending someone money, creditors (whether banks or buddies) risk that a loan will not be repaid properly. A loan may be a mortgage or take the form of bonds of various types.

The purpose of credit derivatives

Credit derivatives are designed to decrease credit risk, the risk that comes with lending. Using credit derivatives, borrowers and lenders can shift credit risk onto other parties, who may earn money for providing protections that work very much like insurance.

Anyone who lends money takes a risk that they will not be paid back. For a bank, it would be useful to be able to lend, yet eliminate some of the risk that a borrower will repay slowly, only partly, or not at all. Credit derivatives are a way of dealing with this risk.

Anyone who borrows takes a risk too. When someone borrows in a foreign currency, for example, the relative value of that currency may change, possibly changing the amount of the loan and its payments in the local currency. Another problem can arise when borrowers take out loans at variable interest rates, running the risk that their payments may change radically -- as many homeowners have discovered. Various types of derivatives can deal with this risk, as well.

People using credit derivatives may be trying to offset credit risk, or they may be trying to make money as speculators.

Types of credit derivatives

A credit derivative may be one of several types, but, in general, it's a contract with a value that changes in response to certain credit-linked events, such as bankruptcies, credit downgrades, missed payments, and defaults.

Credit Default Swaps entitle lenders to money in the event that a borrower defaults. In effect, they are contracts that let banks lend money and, at the same time, make a bet with another party that the loan will not be repaid. The bank keeps the loan on its books while betting against the borrower at the same time.

When a family buys a house in California, they might make a bet with an insurer that it will be damaged in an earthquake. They are not hoping for an earthquake, but they are planning for the eventuality, just as a banker might hedge against a possible loss.

Although a Credit Default Swap is technically not insurance, the lender is covering himself against the chance of default. This kind of credit risk protection is a contract between two parties, and is called an unfunded credit derivative.

A funded credit derivative is created when products are securitized, meaning made into investment products that may be sold to the public. For example, a group of home mortgages might be bundled together so their risk can be sold to investors. The bundled mortgages would be organized into different tranches (French for "slice" or "portion"), with higher-risk tranches paying higher rates and, theoretically, lower-risk mortgages paying investors less.

This kind of credit derivative is called a synthetic Collateralized Debt Obligation (CDO). The idea is to spread risk among many investors, while the institution that creates the CDO takes fees for putting the deal together. Theoretically, the investors know how much risk they are taking on.

Kinds of risk

Risk comes in many varieties. Concentration risk comes when all of an institution's loans are similar. It may already have too many loans in an area, an industry, or a country. If a bank loans mostly to the lumber industry, for example, it will be hurt if the price of wood goes down. Banks try to diversify across many areas to counter this risk.

Currency risk is the risk that a particular currency will change its value enough to hurt the value of a loan or the chance of its repayment.

Counterparty risk is the chance that a party to a Swap or similar contract will not pay. This has happened more than financiers had anticipated when they invented these instruments.

Speculation

A speculator is not acting as a borrower or as a lender. He or she is merely trying to make money by assuming some risk. Speculators generally take positions in view of some event that they believe will cause the value of an asset to move in their favor.

A speculator's outlook is very different from that of a manufacturer trying to finance expansion or of a bank trying to diversify and manage risk. Because their purpose is purely financial, some people think of speculators as profiteers or parasites.

However, speculators bring liquidity to markets, sometimes by buying when no one else will. Their purchases and sales make the gaps between buying and selling prices smaller, and help keep markets efficient.

Credit derivatives transfer credit risk to parties outside a financial transaction. They can help institutions keep their levels of risk appropriate and allow other parties to take on risk in the quest for profit.

To sum up, a credit derivative is one way for someone making a financial contract to manage his or her financial risk. It has a value that depends on the apparent credit risk of an underlying asset. The purpose of a credit derivative is to remove credit risk from the parties to a transaction and shift it onto another party, who may be looking for a way to take on some risk in order to make a profit.