Introduction to Structured Finance

CHAPTER 3

Credit Derivatives

The interest rate derivatives explained in the previous chapter are used in structured finance transactions to control interest rate risk with respect to changes in the level of interest rates. Credit derivatives, in contrast, allow the transfer of credit risk from parties in a structured finance transaction who want to shed credit risk to counterparties willing to accept credit risk.

The eight major credit derivatives according to the British Bankers Association are:¹

• credit default swaps;
• index swaps such as credit default index swaps;
• basket default swaps;
• asset swaps;
• total return swaps;
• portfolio/synthetic collateralized debt obligations; and
• credit-linked notes.

We will discuss all but the last two credit derivatives in this chapter. Portfolio/synthetic collateralized debt obligations are discussed in Chapter 7 and credit-linked notes in Chapter 9.

DOCUMENTATION AND CREDIT DERIVATIVE TERMS

Before describing the various types of credit derivatives, we will discuss the documentation and key terms for credit derivatives. The International Swap and Derivatives Association (ISDA) first developed in 1998 a standard contract that could be used by parties for trades in credit derivatives contracts. While the documentation is primarily designed for credit default swaps and total return swaps, the contract form is sufficiently flexible so that it can be used for the other credit derivatives described in this chapter as well.

Reference Entity and Reference ...