Introduction
Derivatives are financial instruments designed to efficiently transfer some form of risk between two or more parties. Derivatives can be classified based on the form of risk that is being transferred: interest rate risk (interest rate derivatives), credit risk (credit derivatives), currency risk (foreign exchange derivatives), commodity price risk (commodity derivatives), and equity prices (equity derivatives). Our focus in this book is on credit derivatives, the newest entrant to the world of derivatives.
Credit derivatives are financial instruments that are designed to transfer the credit exposure of an underlying asset or assets between two parties. With credit derivatives, an asset manager can either acquire or reduce credit risk exposure. Many asset managers have portfolios that are highly sensitive to changes in the credit spread between a default-free asset and credit-risky assets and credit derivatives are an efficient way to manage this exposure.
Conversely, other asset managers may use credit derivatives to target specific credit exposures as a way to enhance portfolio returns. In each case, the ability to transfer credit risk and return provides a new tool for asset managers to improve performance. Moreover, as will be explained, corporate treasurers can use credit derivatives to transfer the risk associated with an increase in credit spreads. Credit derivatives include credit default swaps, asset swaps, total return swaps, credit-linked notes, credit spread options, and credit spread forwards.
In addition, there are index-type products that are
sponsored by banks that link the payoff to the investor to a specified
credit exposure such as emerging or high yield markets. By far the most
popular credit derivatives is the credit default swap. Credit default
swaps include single-name credit default swaps and basket default
swaps. Credit default swaps have a number of applications and are used
extensively for flow trading of single reference name credit risks or, in
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