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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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