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Tuesday, March 1, 2011

The benefits of credit derivatives

Credit derivatives are exactly what the name implies i.e. derived from credit. In other words the financial instruments such as collateralized bonds are created from a credit instrument such as commercial credit or commercial loans. To illustrate, ABC company takes out a loan for project development from XYZ bank. XYZ bank has several such loan agreements with several companies. XYZ then decides it needs more capital to make more loans so it creates additional bank products such as bonds, that are collateralized by the commercial loans to ABC and other companies. These bonds are an example of credit derivatives since their value is based on the commercial loans.

Types of credit derivatives


Several types of credit derivatives exist, each with it's own purpose, core product, and rules of exchange. The reason derivatives have become more refined over time is because they tend to improve the efficiency of the originators business operations which in turn provides incentive for their creation. A few examples of derivatives are given below:

• Commodities derivatives: Financial instruments that's value is based on commodity value
• Corporate Bonds: Ex-Bundled loans in the form of an actively traded bond
• Credit Derivative Swaps: Ex- Exchanging of derivatives for insurance and/or another derivative.
• Credit Derivative Futures: Obligations to purchase credit derivatives at a future date with optional physical delivery.
• Credit Derivative Forwards: Similar to futures with less regulation and physical delivery

Benefits to buyers and sellers


"Global credit markets today display discrepancies in the pricing of the same credit risk across different asset classes, maturities, rating cohorts, time zones, currencies, and so on. These discrepancies persist because arbitrageurs have traditionally been unable to purchase cheap obligations against shorting expensive ones to extract arbitrage profits." (www.investingbonds.com)

What the above quote means is that credit derivatives in some markets may be under priced due to over supply and inefficiencies in the capitalization of international securities markets. While derivatives are generally favored by financial institutions and companies more than individual investors, there benefits do not discriminate if those taking part in the exchange of the derivatives are able to take advantage of those benefits. A few of the benefits to both buyers and sellers of credit derivatives are listed below.

Benefits to buyers


• Greater market liquidity: The facilitation of trade is enhanced through liquidity
• Leveraged investment: The liquidity of derivatives allows them to be more easily leveraged
• Opportunity to earn fees: Insurers of credit derivatives can earn money if the value of the original financial instruments increase
• Diversification of insurance products: Allows insurers to diversify and thus lower insurance risk.
• Enhanced efficiency via de-bundling of underlying securities and/or commodities
Benefits to Sellers:
• Risk management and/or investment hedging : Ex: Derivative Bond Insurance
• Improved Efficiency of credit risk separation and timed risk management via duration
• Portfolio diversification: Ex. Credit derivative swaps
• Increased capital cash flow: Ex: proceeds from the sale of corporate derivative bonds

An example of a derivative earnings opportunity was in February of 2008 Warren Buffett extended an offer of insurance to mortgage derived bond insurers ailing from the financial effects of the housing market and credit crisis. In this case, the mortgage backed bonds were the credit derivatives, and the bond insurers were financial institutions willing to insure those derivatives with what is termed a 'credit default swap'. However, when the insurers of the credit derivatives experienced a capital squeeze, Buffett stepped in with an offer of liquidity to help keep the bond insurers credit rating high.

Generally speaking, credit derivatives are a sophisticated financial instrument that take significant know how, mathematical ability and business skill to effectively manage and trade. Credit derivatives are primarily used to manage credit risk but may also be used to increase corporate net worth or utilized for arbitrage in financial markets that exchange derivatives directly or via funds that manage derivatives. There are benefits to credit derivatives, notably to the originators of the derivatives who's purpose the financial instrument's creation was designed to serve. However, as with other types of financial instruments, derivatives also have secondary markets, and potential for gain through arbitrage.

Sources:

1. http://en.wikipedia.org/wiki/Credit_derivative
2. http://www.investinginbonds.com/assets/files/Intro_to_Credit_Derivatives.pdf
3. http://biz.yahoo.com/cnbc/080212/23125353.html