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Name: Shaun Cumby
Affiliation:
E-mail: cumbys@gte.net
Date: 07 May 1997
Time: 20:35:48
Credit derivatives certainly are real, albeit undeveloped and illiquid. This, however, should be expected for such a young market. There are four products that dominate the market: total return swaps, default swaps, credit-linked notes and spread options (in order of personally observed market activity). The market requires standardization of documentation (forthcoming from ISDA) and regulatory and accounting treatment (in progress) to flourish. The further education of the credit industry on the portfolio approach to credit risk management will spur development and trading further.
Banks, insurance companies and hedge funds are the most active players in the credit derivs market. Large domestic banks are generally buyers of credit protection on corporate names that have reached maximum exposure limits or are no longer in favor with the bank. Smaller banks and insurance companies are often the sellers of financial protection, as this derivative mimics a loan participation. There are key advantages to writing a credit derivative relative to loan syndicate participation, and a few drawbacks. Banks and insurance companies have the credit evaluation experience to evaluate the credits underlying default swaps, and are the target customer of most credit derivs dealers. The default swap market can be quite illiquid, but can also accomodate substantial size and customization when you are willing to work with a dealer to achieve the desired credit protection or exposure. There are several ways to price default swaps, from arcane theoretical models to the most basic replication of cash economics.
Total return swaps are often used by hedge funds to gain access to odd securities, to simply operationally intensive trades, but mostly to gain leverage. For example, a fund may purchase a security, index or basket of securities from a dealer through a total return swap with no initial value. The hedge fund may be required to post collateral, but the leverage gained is still substantial. The dealer monitors the asset, provides cash management, marks the position, provides reports and handles the cash trading. In turn, the fund must pay the dealer for this service and 'balance sheet rental'. The cost of the total return swap is similar in concept to funding the security position. The dealer's funding cost, the actual or perceived funding cost of the hedge fund, and the credit quality of the reference asset are all key inputs determining the spread, usually quoted over 3 month Libor, that is applied to the notional amount of the total return swap. Credit-linked notes are created for the same reason as total return swaps, but are used by market participants that want to put cash to work by purchasing a note.
Finally, credit spread options are used to take on exposure or protection to a specific asset. There are several innovative uses for credit spread options, that were perhaps done in the past, but without any methodology for valuation. This market rarely trades.
Please feel free to e-mail me with further questions.
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