The Trade Lifecycle: Behind the Scenes of the Trading Process

5

Credit Derivatives

This chapter was written in collaboration with Dr Geoff Chaplin, Reoch Credit Partners LLP.

We shall now examine one asset class in detail. We have chosen credit derivatives because they are topical, complicated and combine many of the features of other asset classes and derivatives described in the previous two chapters.

5.1 INTRODUCTION

You cannot buy a quantity of credit in the way you can buy a barrel of oil or shares in a company. However, credit risk in the form of counterparty risk (see Chapter 12) has been known and managed since financial trading began. In addition, certain products such as bonds and loans carry intrinsic credit risk: that the underlying issuer or borrower will default and fail to fulfil their obligations.

Since many companies were left with unwanted credit risk on their books, a market was started to trade credit risk with other companies that were prepared to carry the risk in return for some financial incentive.

As ever, the market started with simple products and has advanced to the more complicated and structured products, such as collateralised debt obligations (CDOs).

We begin our discussion of credit derivatives by examining all of the main products, and then show how credit products differ from other asset classes.

5.2 CDS

A credit default swap (CDS) is a contract between two parties referencing an entity or asset: a buyer of protection, also known as the seller of risk; and a seller of protection, also called the buyer ...