Credit Derivative Swap Index Tranche: School-To-College

imagesWe all have heard of CDS (Credit Derivative Swap) But, how many of us have the real idea & concept of CDS cleared with us? I guess very few people. So, here we are ready with our today`s blog which will talk about CDS, its basic concept & origin with its structurally enhanced form/product known as CDX-“Credit Derivative Index Tranche” .

Meaning: In finance, a credit derivative refers to any instrument and technique designed to separate and then transfer the credit risk of the underlying loan. It is a securitized derivative whereby the credit risk is transferred to an entity other than the lender.

Definition Of Credit Derivative: A credit derivative is a financial instrument that transfers credit risk related to an underlying entity or a portfolio of underlying entities from one party to another without transferring the underlying. The underlying may or may not be owned by either party in the transaction.

Origin: The market in credit derivatives started from nothing in 1993. By 1996 there was around $40 billion of outstanding transactions, half of which involved the debt of developing countries. Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations.

Market: Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%. The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates.

Classification Of Credit Derivatives: Credit derivatives are broadly divided into two categories: funded credit derivatives and unfunded credit derivatives.

  1. An “unfunded credit derivative” is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets.
  2. A “funded credit derivative” involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. (The protection buyer, however, still may be exposed to the credit risk of the protection seller itself. This is known as counterparty risk.)

Unfunded credit derivative products include the following products:

Funded credit derivative products include the following products:

Credit Derivative Swap Index Tranche: One of the most significant developments in financial markets in recent years has been the creation of liquid instruments that allow for the trading of credit risk correlations. Prime among these instruments are CDS index tranches- CDX. A CDX is an insurance contract covering default risk on the pool of names in the index. Index contracts differ slightly from single-name securities. The main difference is that a buyer of protection on the index is implicitly obligated to pay the same premium, called the fixed rate, on all the names in the index. In addition, index contracts restrict the eligible types of credit events to bankruptcy or failure to pay.

In the case of a credit event, the entity is removed from the index and the contract continues (with a reduced notional amount) until maturity. The market liquidity of CDX is enhanced by:

  1. The emergence of widely accepted benchmark indices, which comprise the most liquid single-name CDS contracts in the market and have a group of global dealers committed to market-making;
  2. A clear geographical focus, relatively stable sector-rating composition and standardised maturities for each index; and
  3. The availability of two different contract formats. We consider each element in turn.

Valuation/Pricing: Pricing of credit derivative is not an easy process. This is because:

  1. The complexity in monitoring the market price of the underlying credit obligation.
  2. Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable.
  3. The incidence of default is not a frequent phenomenon and makes it difficult for the investors to find the empirical data of a solvent company with respect to default.
  4. Even though one can take help of different ratings published by ranking agencies but often these ratings will be different.

Areas Of Concern: Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market, and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.

Conclusion: CDX give investors, i.e; sellers of credit protection, the opportunity to take on exposures to specific segments of the CDS index default loss distribution. Each tranche has a different sensitivity to credit risk correlations among entities in the index. One of the main benefits of index tranches is higher liquidity. This has been achieved mainly through standardization  yet it is also due to the liquidity in the single-name CDS and CDS index markets. In contrast, possibly owing to the limited liquidity in the corporate bond market, securities referencing corporate bond indices have not been actively traded.

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