I-
Birth of credit derivative:
• The term credit derivative is used for the first time
in 1992 during a conference of the International Swaps and Derivatives
Association (ISDA).
• This category of tools has been created in order to
compensate for the shortage of the management of the credit
risk.
• The first credit derivative has been designed by Wall
Street business banks to face major counterparty risks on swap
portfolios.
• So, to reduce their risks, these banks have extracted
and given up their credit risks.
II- Definition of credit derivative:
credit derivative = products that enable the valorisation and
the negotiation of the credit risk of a subjacent asset independently
from the other market risks.
• Reasons of the birth of credit derivative:
o Protect from the credit risk in a more efficient way
o Increasing gap of sophistication between the management of
market risks and credit risk
o New cautious regulation
o Exponential rise of derived activities leading to the growth
of counterparty risks.
All the types of credit risks are treated: banking, corporate,
sovereign, investment grade or high yield. Those products enable
to transfer, exchange, negotiate the credit risk of a firm that
does not have any negotiable debts.
• credit derivatives are financial tools that enable to
promote and negotiate the credit risk of a subjacent asset (Stocks,
Bonds…). Their main characteristic is to extract the credit
risk of an asset without transferring the ownership and the
management. They are off-balance sheet tools, by mutual agreement
they transfer the credit risk of a reference asset held by the
buyer to the seller of the protection. It is therefore a synthetic
financial product, which value is conditioning by the occurrence
of a credit event, and not by the effective realisation of a
loss.
• The credit events are:
o Bankrupcy
o Defect of payment
o Restructuration
III- Why we need credit derivative?
Because they enable:
• The separation of market and credit, and to transfer
this risk to other interveners on the market.
• The bank to keep the credit and transfers the risk to
others.
•The hedging of the credit risk: The use of derived credits
as margin is to take a position on the derived market, such
as any loss on the subjacent asset in the cash market, to be
compensated by a gain on the position in by-products.
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