CH16 - Credit Derivatives

Question 1

List the three uses of Credit Default Swaps (CDSs)

Answer 1

1. Protection of a Credit Exposure
2. Investment in Credit: Long Credit
3. Speculation in Credit: Shorting Credit

Question 2

1. Protection of a Credit Exposure

Answer 2

• Needs arise when origination success leads to proportionately high exposures or when the financial situation of a counterparty deteriorates
• CDSs provide a convenient way to execute a transaction without being in the undesirable position of informing the client or customer that its credit is not well regarding
• Issue is basis risk: chance that there is a difference between the actual loss and the compensation received from the settlement.

Question 3

2. Investment in Credit: Long Credit

Answer 3

• Motivation of most protection sellers is to make money by taking an exposure to credit risk, that is, to invest in credit risk
• If the seller is comfortable with the creditworthiness of the reference entity and if the price is adequate for the risk, then the seller puts its capital at risk in exchange for the CDS premium
• Advantages: opportunity to take on risk that is isolated from other types of risk present in bonds and stocks; taking a position does not require cash

Question 4

3. Speculation in Credit: Shorting Credit

Answer 4

• Hedge funds often monetize a view on the credit trend of a company/country. Often, the view is a negative one and the hedge will “short the credit”: i.e. buy protection via a CDS without having any exposure
• This transaction delivers a profit in case the reference entity deteriorates or defaults
• The presence of large short positions calls into question the reference entity’s creditworthiness, and thereby restricts its sources of liquidity and capital that might otherwise have been available in the lending markets.