Credit Derivatives Coursework

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Credit Derivatives Coursework

Introduction

In the modern world of finance, credit derivatives are becoming increasingly popular. The existence of various credit risk management techniques is an indication. The techniques were necessitated by the over threat credit exposed businesses for both the lender and borrower.[1] Thus, credit derivatives work by reducing the risk associated with borrowing, especially to the lender. Therefore, it works as insurance in case debtors default, covering any possible losses that may then arise.[2] Conversely, the derivatives single certain particulars of the credit risk rather than its economic sense. The process attracts adequate discretion such that the party whose risk is transferred is not always aware. This is often done to protect customer relations. Current paper aims to describe credit derivatives and instruments of financing trade. It eventually addresses the association between credit derivatives and financing instruments, including the use of derivatives in trade.

Financial instruments are legally binding agreements between two parties to transfer something of value which in most cases infer money but are not limited to it. The parties can be individuals, governments, banks or insurance companies. On the other hand, there are other financial instruments that have their value derived from other assets and hence have an abstract value.[3] These financial derivatives include shares and future contracts. However, the schema of the financial instrument can be considered in terms of equity, mutual funds, bonds, deposits, real estate, gold and debt.[4] These financial instruments are associated with some market risks because at the time of transaction of that financial instrument, it might have a lower or negative value to the projected investment value. Thus, an investor is exposed to market risks of liquidity, credit, currency and interest rates.[5] To protect investments, the existence of this nature necessitated a feedback mechanism.  /p>

The financial mechanisms through which risks from credit are transferred from either the borrower or a lender to another party are known as credit derivatives.[6] Credit derivatives are bilateral agreements that derive their value from calculations based on the credit and the lenders’ or borrowers’ credit history.[7] Credit derivatives were borne from the need by financial institutions to diversify credit risks. To literally put it in context, there can be cases where bank assumes a potential probability for a customer to default in their loan obligation. In a counter measure, the bank can get into an agreement with another entity to cover the loan in case it is not paid. However, the bank still monitors the borrower. The example above projects a situation of failure to pay. Nevertheless, other credit risks such as bankruptcy, dept restructuring, obligation default, and repudiation can exist.[8] The common credit derivative types are swaps, futures and opinions.      

The most popular among the types of credit derivative is the credit swap or credit default swap (CDS). CDS is a mutual bilateral contract that transfers a credit risk from one entity to another in case the reference party defaults. In the financial agreement the protection seller (lender) is always paid a periodic fee on an annual basis, calculated on the borrowed amount by the protection buyer. Upon the occurrence of the credit risk or event by the reference part, the protection seller has the responsibly of paying the protection buyer to protect them from associated loses.[9] The payment value is called the notional amount. A CDS can also cover more than one reference entity which in a retro respect is always three to ten entities. Consequently, this amounts to a CDS basket or portfolio products. In the incident of default of the first credit event, the protection buyer is compensated and the financial agreement is terminated. The main shortcoming of CDS is loss of profit, making oopportunity for the protection buyer due to loss of exposure to a credit event.

Therefore, credit derivatives offer an incentive in credit risky investments. The structural arrangements of credit default swaps do not necessarily require a principal amount for the protection seller. As a result, the financial benefit is availed by getting into a credit swap without affecting the financial position of an entity on the balance sheet.[10] It is because the credit event does not need to be paid. As such, it is increasingly becoming lucrative to accumulate low quality assets with high funding costs. This case scenario is present in JP Morgan, Citigroup and Bank of America whose capital is in billions, while their derivative exposure mainly consists of equities and special reserves in trillions. However, caution must be taken in valuing the risk and the possibility it might have on the operations of the business. Financial instruments have the capability of changing due to liquidity, volatility and disruption of financial markets.     

In conclusion, financial institutions as sources of capital mobilization must always minimize the risks associated with financial borrowing. The various financial instruments, for credit derivatives for which financial liability is reduced against financial assets, are a milestone to lending. Credit derivatives give an opportunity of also making more profits with the aim of reducing credit risk, especially for the protection seller. In this view, the environment in which the credit derivative operates must be highly customized. Furthermore, the underlying pace through which derivatives are growing in the financial markets warrants this kind of risk control. The overall operation framework for credit derivatives is a cross cutting analysis in inventory risks through summing the possibilities in credit risks and market risks. If these risks are to be experienced for a long time, then credit derivatives can destabilize financial markets.

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