Derivatives Credit : Credit Derivatives part II


As I left the space to define the various types of credit derivatives so here we go:

Credit default swap: Credit default swap can literally be defined as an option to swap a credit asset for cash, should it default. A credit default swap is essentially an option, and option bought by the protection buyer, and written by the protection seller. The strike price of the option is the par value of the reference asset. Unlike a capital market option, the option under a credit default swap can be exercised only when a credit event takes place.

It can be put as CDS is simply an exchange of cash flows between two “counter parties” Buyer and Seller. Exchanges of cash flows, especially those based on some nominal amounts are called SWAPS on the OVER THE COUNTER (OTC) MARKETS, where most of them take place.

Total return swap: As the name implies, a total return swap is a swap of the total return out of a credit asset swapped against a contracted prefixed return. The total return out of a credit asset is reflected by the actual stream of cash flows from the reference asset as also the actual appreciation/depreciation in its price over time, and can be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements.

Credit linked notes: Credit linked notes (CLNs) are a securitized form of credit derivatives which converts a
credit derivative into a funded form. Here, the protection buyer issues notes or bonds  which implicitly carries a credit derivative. The buyer of the CLN sells protection and pre-funds the protection sold by way of subscribing to the CLN. Should there be a credit event payment due from the protection seller, the amounts due on the notes/bonds on account of credit events will be appropriated against the same and the net, if any, will be paid to the CLN holder. The CLNs carry a coupon which represents both the interest on the funding, as also the credit risk premium on protection sold. Obviously the maximum amount of protection that the CLN holder provides is the amount receivable on account of the CLN, that is, the interest and the principal.

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