The subject matter of a credit derivative transaction is a credit asset, that is to say, an asset or contract that gives rise to a relationship of a creditor and debtor. However, credit derivatives are usually not related to a specific credit asset but trade in the generic risk of default of a particular entity. The entity whose risk of default is being traded in is commonly referred to as the reference entity. There are cases where the credit derivative is linked not to the general default of the reference entity but the default of specific asset or portfolio of assets. This is called the reference obligation, reference asset, or the reference portfolio.

The party that wants to transfer the credit risks is called the protection buyer and the party that provides protection against the risks is called the protection seller. The two are mutually referred to as the counterparties. Protection buyer and protection seller may alternatively be referred to as the risk seller and the risk buyer, respectively.

We have mentioned above that it is not necessary for the protection buyer to actually own the reference asset: he might either be using the credit derivative deal as a proxy to transfer the risk of something else that he holds, or may be doing so for trading or arbitraging reasons. Irrespective of the motive, a derivative deal does not necessitate the holding of the reference asset by either of the counterparties, by which it is also obvious that the protection buyer need not hold the reference asset of the same value or for the same tenure for which the derivative deal is written.

Therefore, like most other derivatives, credit derivatives are written for a notional value, usually in denominations of $1 million. The premium to be paid by the protection buyer, and the protection payment to be made by the protection seller, are both computed with reference to this notional value. For the same reason, the tenure of the credit derivative does not have to coincide with the tenure of the credit asset.

Since the derivative deal focuses on the credit risk, it is necessary to define the credit risk. This is done by defining credit events. Credit events are the specific events on the happening of which protection payments will be made by the protection seller to the protection buyer. Parties may define their credit events; in OTC transactions taking place under the standard documentation of the International Swap and Derivatives Association (ISDA) standard documentation, credit events are chosen from out of the list of credit events specified by the ISDA. In the case of a total-rate-of-return swap, a type of a credit derivative discussed later, the entire credit risk of volatility of returns from a credit asset, without reference to the reasons therefore, is transferred to the protection seller, and therefore, the definition of credit events is relevant only for termination of the swap on its occurrence.

The premium is what the protection buyer pays to the protection seller over the tenure of the credit derivative. If there is no credit event during the tenure of the deal, the protection buyer pays the premium, and on efflux of time, the deal is closed. If there is a credit event, there will be protection payment due by the protection seller to the protection buyer, and the deal is closed without waiting for the tenure to be over. The protection payments or credit event payments are what the protection seller has to pay to the protection buyer should the credit event happen. The protection payment is either the outstanding par value plus accrued interest (computed with reference to the notional value) of the reference asset, or the difference between such par value plus accrued interest and the post-credit-event market value of the reference asset. In the former case, the protection buyer delivers the reference asset to the protection seller (called physical settlement) and the latter case, there is no transfer of the credit asset (called cash settlement) as the protection seller merely compensates the protection buyer for the losses suffered due to the credit event.

In either case, the protection payments are not connected with the actual losses suffered by the protection buyer.

In case the terms between the parties have fixed physical settlement as the mode, the protection buyer shall be required to deliver a defaulted obligation of the reference entity on default. Generally, the definition of such defaulted obligations is broad enough to allow the protection buyer to buy from out of several available obligations of the reference entity. Such obligations are called deliverable obligations. Both reference obligations and deliverable obligations are defined usually by characteristics. Hence, any obligation of the reference entity that satisfies the characteristics listed will be deliverable obligation. Quite obviously, the protection buyer will have the motivation to deliver the cheapest-to-deliver obligations.

For example, let us suppose a bank has an outstanding secured loan facility of $65 million, payable after seven years, given to a certain corporation, say X Corporation. The bank wants to shed a part of the risk of the said facility, say $50 million, and enters into a credit derivative deal with a counterparty, the protection seller. The bank is the protection buyer in this deal. The derivative deal is done for a notional value of $50 million for X Corporation as the reference entity and, say, with a tenure of five years. The reference obligation is "senior unsecured loans or bonds of the reference entity." The parties agree to physical settlement. In this deal, the bank will pay a premium of 80 basis points to the protection seller for the full term of the contract, that is, five years if a credit event does not occur. If a credit event occurs, the bank stops making payments up to the date of the credit event and seeks protection payment.

The type of credit derivative described in this illustration is called a credit default swap or simply default swap and is the most common form of a credit derivative.

In our example, the bank is buying protection basically for hedging purposes. However, it may be noted that there are mismatches between the actual loan held by the bank and the derivative. The amount of the loan is $65 million, where the notional value of the derivative is only $50 million. The actual loan is a secured loan facility, while the reference asset for the credit derivative is a senior unsecured loan. The term of the loan is seven years, while the term of the derivative is five years. We wish to emphasize that there may be complete disconnect between the actual credit asset, if at all held by the protection buyer, and the credit derivative. For the purpose of our discussion, it would be all the same if the protection buyer did not have any loan given to X Corporation, and was simply trying to buy protection hoping to make a profit when the premium for buying protection against X Corporation went above 80 basis points.

Since the transaction of credit derivative is referenced to "senior unsecured loans or bonds of X Corporation," the credit events (as defined by the parties) will be triggered if there is such event on any of the obligations of X Corporation that satisfy the characteristics listed for the reference obligations. Generally speaking, if there is a default on any of the loans or bonds of X Corporation, or if X Corporation files for bankruptcy, it would trigger a credit event.

The obvious purpose of the party buying protection in this case is to partially hedge against the risk of default of the exposure held by the protection buyer. The protection buyer, the bank in our example, actually holds a secured loan, but buys protection for a senior unsecured loan for two reasons. First, since the market trades in general risk of default of X Corporation, the defaults are typically defined with reference to unsecured loans as they are more likely to default than secured loans. Second, for the protection buyer the protection is stronger when it is referenced to an inferior asset than the one actually held by the bank in our example.

The protection seller is earning a premium of 80 basis points by selling protection. This party, of course, is exposed to the risk of default of X Corporation. In normal course, to create the same exposure, the protection seller would have to lend out money to X Corporation. In this case, the protection seller has acquired the exposure without any initial investment (see later in this chapter about funded derivatives). The objective of the protection seller might be simply to create and hold this exposure as a proxy for a credit asset to X Corporation. Alternatively, the protection seller might also be viewing the transaction as a trade: this party would stand to gain if the cost of buying protection against X Corporation declines to below 80 basis points. The protection seller may encash this gain either by buying protection at the reduced price, or by other means.

If the credit event does not happen over the five-year term of the contract, the derivative expires with the protection buyer having made periodic premium payments to the protection seller. If the credit event does happen, the protection buyer may choose to make a physical settlement. In that case, the protection buyer may well deliver an unsecured bond of X Corporation, as evidently, the possible recovery on the secured loan that X Corporation is holding will be better than the market price of the unsecured bonds of X Corporation. Thus, if the protection buyer purchases such bonds at a price of 30%, he would stand to make 70% of the notional value because the protection seller will obligated to pay to the protection buyer the par value of the defaulted assets that satisfy the characteristics of the deliverable obligations. The protection buyer may continue to hold the secured loan and recover it through enforcement of security interests or otherwise.

Through a credit derivative contract, the protection buyer transfers defined credit risks of a reference asset to the protection seller. Assuming the protection buyer holds the reference asset, as is the case in the example above, what is the impact of the derivative on the protection buyer? The protection buyer still holds the reference asset, but has now transferred the defined credit risks. Instead, the protection buyer now has a risk on the protection seller. Should a defined credit event take place, the protection buyer is not concerned with receiving interest or principal on the reference obligation from the obligor; the protection buyer is rather concerned about getting the protection payment from the protection seller. So, there is a substitution of obligor risk by counterparty risk.

As far as the protection seller is concerned, the protection seller has not bought the reference asset, but is exposed to risks and rewards of the reference asset. Should the reference asset not default, the protection seller continues to get the premium that is obviously based on the credit risk of the obligor, and is therefore a reward related to the reference obligor. Should the credit event take place, the protection seller is exposed to the risk of having to make protection payments.

In other words, the protection seller has assumed risk and reward in the obligor, without actually lending to the obligor. The obligor is now the synthetic asset of the protection seller, as by the derivative contract, the protection buyer has synthetically substituted obligor exposure by counterparty exposure, and the protection seller has synthetically created a new asset, namely, exposure in the obligor.

Credit derivatives deals provide a new opportunity of synthetically creating assets—without actually creating a portfolio or lending. Instead of originating a loan, virtually the same position can be created synthetically by selling protection. (Note that this will be even more true in the case of total-rate-of-return swaps, discussed later, where the parties replicate the actual cash flows from a reference obligation.)

The credit asset so created is referred to as synthetic asset or unfunded asset.

The motivations of the protection buyer in our above example are easily understandable—the bank wants to transfer the risk of holding the exposure in X Corporation without transferring the asset. But a primary question arises on the motivation of the protection seller: Why would that party be willing to write protection on something never actually created by him.

Briefly speaking, credit derivatives have provided an easy way for banks to gain exposures in credit risks without having to actually create assets. Consider a bank, say Bank A, that specializes in lending to the office equipment industry. Over the years, this bank has acquired a specialized knowledge of the office equipment industry. Suppose further that there is another bank, Bank B, that, say, specializes in the textiles industry. Both these banks are specialized in their own industries, but both suffer from the risks of portfolio concentration. Bank A is concentrated in the office equipment industry and Bank B is focused on the textiles industry. Understandably, both banks should diversify their credit portfolios to be safer.

One obvious option for both of bank is as follows: Bank A should invest in an unrelated portfolio, say textiles, while Bank B should invest in a portfolio of credits in which it has no credit exposure, say, the office equipment industry. Doing so would involve inefficiency for both the banks, as Bank A does not know enough about the textiles industry as Bank B does not know anything about the office equipment industry.

Here, credit derivatives offer an easy solution: Without transferring their portfolio or reducing their portfolio concentration, both banks could buy into the risks of each other's portfolios by credit derivative deals. By doing so, both banks would have diversified their risks. Moreover, both banks have diversified their returns, as the premiums being earned by the derivative contract represent return from the portfolio held by the other bank.

The above example has depicted credit derivatives being a bilateral transaction—as a sort of a bartering of credit risks. As a matter of fact, credit derivatives can be completely marketable contracts: The credit risk inherent in a portfolio can be securitized and sold in the capital market just like any other capital market security. So anyone who buys such a security is inherently buying a fragment of the risk inherent in the portfolio, and the buyers of such securities are buying a fraction of the risks and returns of a portfolio held by the originating bank.

Credit derivatives allow parties who are completely strangers to the banking market to eat into the rewards and bear the risks of banking assets, which would be otherwise not be possible. For example, a capital market participant buying a synthetic security with an embedded derivative feature gets to create a synthetic loan asset. An insurance company would not have been allowed to enter the banking market at all, but credit derivatives enable it to sell protection, which is synthetically the same as writing a loan itself. This discussion also reveals how credit derivatives could replicate credit assets in different markets and geographies.

Credit derivatives succeed in creating a new derivative product parallel to a cash bond or obligation. This synthetic product can have structured or leveraged risk/reward positions, and therefore, can be a device for the markets to allow structured trading in a credit asset without, of course, investing in the asset at all.

A credit derivative may be a transaction between two counterparties, or may be a capital market transaction. Bilateral transactions between parties or dealers are normally referred to as OTC deals, since they take place between parties on an over-the-counter basis, as opposed to exchange-traded derivatives. The other possible format of a credit derivative deal is embedding the derivative into some capital market instrument, and offering such instrument to investors in the capital market.

The most basic distinction between capital market deals and counterparty or OTC deals is based on who the counterparty is. Obviously, the counterparty for any credit derivative deal is a specific party, and it is impossible to envisage a credit derivative where the "capital market" is the counterparty. However, capital market transactions intend to transfer the exposure to the capital market instruments by interposing special purpose vehicles (SPVs). In a capital market transaction, the risk is first transferred by the protection buyer to the SPV, which in turn transmits the risk into the market by issuing securities that carry an embedded derivative feature.

A credit derivative deal might either be linked with a single reference entity, called a single-name default swap, or a portfolio of entities, called a portfolio default swap. Since the market is essentially OTC, it is intermediated by dealers and brokers. For well-known reference entities, the market is quite liquid and bid-ask spreads are quite fine. Another very liquid part of the market is standardized index trades, discussed later.

Sometimes, credit derivative deals are embedded into capital market securities to make it an investment product. This takes the form of collateralized debt obligations (CDOs). CDOs might relate either to a pool of assets sitting on the balance sheet of a bank (called a balance sheet CDO) or a bunch of reference entities drawn from the market (called an arbitrage CDO).

OTC deals and capital market deals differ in terms of pricing as well—the pricing of OTC deals is based on prices quoted for the specific reference entity or index in the market. The risk is assessed and priced by market mechanism, which may inherently adopt one or more models for pricing credit derivatives. In a bespoke capital market transaction, the obligor portfolio is mostly diversified and the risk is assessed by the quality and extent of diversity of the pool. The pricing of the risk transfer is mostly implied by the negative carry inherent in the assets and liabilities of the SPV—that is, the rate of return that the investments of the SPV fetch, and the weighted average coupon of the liabilities.

From the viewpoint of obligor specification, there are two types of credit derivatives: a single-obligor derivative (or single-name derivative) and a portfolio derivative. As implied by the name, a single-obligor credit derivative refers to an obligation of a specific named obligor, whereas a portfolio trade refers to specific obligations of a portfolio of obligors.

In either case, the reference is to obligations of the reference entity, such as an unsecured loan, or unsecured bond of the obligor. Parties may define the obligation either by making it specific such as a particular loan or a particular bond issue, or give a broad generic description—such as any loan or any bond and so on. Most of the OTC transactions are referenced to a generic senior unsecured loan of the reference entity, which is primarily chosen as representative of the risk of default, mostly leading to a bankruptcy, of an obligor on a plain unstructured credit.

In the case of portfolio default swaps, the portfolio may be a static portfolio or a dynamic portfolio. As implied by its name, a static portfolio is one in which the constituents of the obligor portfolio will remain fixed and known over time. In the case of a dynamic portfolio, though the total value of reference portfolio remains fixed, its actual composition may change over time as new obligors may be introduced into the pool, usually for those that have been repaid or prepaid, or those that have been removed due to failure to comply with certain conditions. It is obvious that the selection of the names forming part of the dynamic portfolio will be based on definite selection criteria, elaborately laid down in the transaction documents, so as to ensure that the reinstatement of obligors over time does not change the portfolio risk.

Where the credit derivative deal relates to a portfolio, it is possible to create tranches of the risk arising out of it. We have earlier briefly discussed the concept of tranches. Hence, it is possible for the protection buyer to come up with several tranches—say, junior, mezzanine, and senior tranche, or say 0% to 4%, 4% to 8% tranche, and so on. The protection buyer may either buy protection on all these tranches, or one or more than one of these. Such trades are called structured credit trades, or structured portfolio trades. The word "structured" puts such trades in line with other segments of structured finance, such as securitization. The word "structured" also implies that the number and sizing of the tranches are structured to suit investors' appetite for risk and urge for returns.

Another common variety of a structured credit derivatives prevailing in the market is called a basket derivative, where the reference asset is a basket of obligations, and the credit event is nth to default in a basket, let us say, first to default in a basket of 10 obligors. So the deal is referenced to a basket of 10 defined obligors, each with a uniform notional value, and when any one out of the basket becomes the first to default, the protection payments will be triggered, and thereafter, the deal is terminated. Effectively, this might be a very efficient way of buying protection against a portfolio of 10 assets, while paying a much smaller premium. This is because the joint probability of more than one obligor defaulting in a basket of 10 obligors is very small, while the probability of any one of the 10 defaulting is much higher. So the losses of the protection seller are limited to only one of the 10 obligors, while at the same time providing needed protection against a larger portfolio to the protection buyer.

At times, parties might even transact a basket deal where protection is bought for the second-to-default obligor. The intent here is that the first or threshold risk will be borne by the protection buyer, but any subsequent loss after the first default will be transferred to the protection seller. Conceptually, the protection buyer has limited losses to the first default in the portfolio, seeking protection from the protection seller for the second default. The third or subsequent default in the portfolio is unprotected, but that is only a theoretical risk, as the probability of three defaults in an uncorrelated portfolio is nominal. Likewise, one may think of an nth to default basket swap.

Basket default swaps, like all portfolio trades, are structured with the parties taking a view on the inherent correlation in the basket. The higher the correlation in the basket, the risk of the first-to-default protection seller comes down, and that of the second-to-default protection seller goes up.

The idea of portfolio credit trades, structured or otherwise, was carried further with the introduction of the index trades and gained tremendous popularity. A single-name credit derivative allows the parties to trade in credit risk of a particular entity. A portfolio derivative allows parties to transact trade in the credit of a broad-based portfolio, say, a portfolio of 100 U.S. corporates. The selection of these 100 U.S. corporates may be done by the person who structures the transaction. However, to allow parties to trade on a common portfolio, index trades construct a standard pool of n number of names (or securities), and allows various traders to trade in such common portfolio. The common portfolio is known as the index, in line with indices of equities, bonds, or other similar securities. The advantage of index trades is that they allow the carrying out of structured trades in a generalized portfolio, so capital market participants may take views on the general corporate credit environment in the United States, or Europe, or so on. In view of their advantage over bespoke portfolio trades, that is, portfolios of names selected by the structurer, index trades have quickly grown to become a very large component of the credit derivatives market.

The protection buyer is the entity that seeks protection against the risk of default of the reference obligation. The protection buyer is usually a bank or financial intermediary that has exposure to credit assets, funded or unfunded. In such a case, the primary objective of a protection buyer is to hedge against the credit risks inherent in credit assets. The credit assets in case of OTC transactions are mostly corporations, or sovereigns, primarily emerging-market sovereigns. In the case of several CDOs, the assets can diversified obligor pools representing a broad cross-section of exposure in various industries. There have been several cases where risks on a portfolio of a very large number of obligors have been transferred through derivatives, for example, small- and medium-enterprise (SME) loans, auto leases, and so on.

At times, dealers could be buying protection for shorting credit assets, for the purpose of arbitraging by selling protection or otherwise gaining by way of a widening of credit spreads on the reference entity. Buying protection is the same as going short on a bond. The protection buyer gains if the credit quality of the reference entity worsens. One may also visualize that usually, among the bond market, equity market, and the credit derivatives market, there is a degree of correlation. Hence, the protection buyer shorts exposure on the entity by buying protection.

Buying of protection is also seen by the market as a convenient way of synthetically transferring the loan, while avoiding the problems associated with actual loan sales. Sale or securitization of loans involves various problems, depending on the jurisdiction concerned, relating to obligor notification, partial transfers, transfer of security interests, further lending to the same borrower, and so on. (Apart from the procedural issues related to transfer of loan portfolios, a major legal risk in a loan sale is generically referred to as the "true sale" risk, that is, the possibility that the sale of the loans will either be disregarded by a court or undone by a consolidation of the transferee with the transferor. For a detailed discussion on the true sale problems, see Kothari [2006].) Synthetic transfers, in contrast, avoid all of these problems, as the reference asset continues to stay with the originator.

In credit derivatives documentation, the protection buyer is also referred to as the fxed-rate payer. Perhaps this term is the remnant of the interest rate swap documentation.

Earlier, we discussed briefly the motivations of the protection seller. To reiterate, the protection seller is mainly motivated by yield enhancement, or getting to earn credit spreads from synthetic exposures where direct creation of loan portfolios is either not possible or not feasible. In OTC transactions, the major protection sellers are insurance companies, banks, hedge funds, equity funds, and investment companies. In the case of CDOs, the protection sold is embedded in securities that are mostly rated, and the investors acquire these securities based on their respective investment objectives.

The protection seller may also be taking a trading view and expecting the credit quality of the reference entity to improve. Selling protection is equivalent of longing a bond—as the quality of the underlying entity improves, the protection seller stands to gain.

In credit derivatives documentation, the protection seller is also referred to as the floating-rate payer.

Typically, a credit derivative implies an undertaking by the protection seller to make protection payments on the occurrence of a credit event. Until the credit event happens, there is no financial investment by the protection seller. In this sense, a credit derivative is an unfunded contract.

However, quite often, for various reasons, parties may convert a credit derivative into a funded product. This may take various forms, such as:

The purpose of converting an unfunded derivative into a funded form may be variegated: It could either be a simple collateralization device for the protection buyer or may be the creation of a funded product that features a derivative and is therefore a restructured form of the original obligation with reference to which the derivative was initially written. When the funded derivative takes the form of a fixed income security, it is referred to as a credit-linked security or credit-linked note, which implies that a credit derivative has been embedded in a fixed-income security.

Credit events are the contingencies or the risk of being transferred in a credit derivative transaction. There are certain credit derivatives, such as total-rate-of-return swaps, where the reference to credit event is merely for closing out the transaction because the cash flows are swapped regularly; but most credit derivative deals refer to an event or events, upon the happening of which protection payments will be triggered.

The ISDA's standard documentation lists and elaborates different credit events for different types of credit derivative deals. For standard credit derivatives, there are six credit events: bankruptcy, failure to pay, obligation default, obligation acceleration, repudiation or moratorium, and restructuring. Parties are free to choose one or more credit events. If the parties use a non-ISDA document, they can define their own credit events as well. In most capital market transactions, credit events are given a structured meaning by the parties.

In OTC trades, the most common credit events are bankruptcy, failure to pay, and restructuring. Restructuring as a credit event has had a checkered history in the credit derivatives business, as a mere restructuring is not a case of default in common banking or credit parlance, and yet triggers protection payments in the case of credit derivatives. If a protection buyer holds a loan that gets restructured, say, with the borrower seeking extension of maturity by something like two years, theoretically, the protection buyer has not lost much money (except maybe on account of impairment of credit of the borrower), and may still seek compensation by delivering a cheapest-to-deliver asset of the reference entity that he may acquire from the market. To put reasonable curbs on what may be delivered pursuant to a restructuring event, ISDA documentation gives certain options to parties, essentially in the form of maturity limitations of the deliverable obligations.

It is quite possible for credit derivatives trades to not include restructuring as a credit event at all—for example, index trades do not include restructuring.

In the case of credit derivatives on asset-backed securities, the generic definitions of "bankruptcy" and "failure to pay" would obviously not be applicable; hence, there are unique credit events in the case of such contracts.

Earlier, we discussed the relevance of notional value in a derivative deal. Like all derivative deals, credit derivatives also refer to a notional value as the reference value for computing both the premium and the protection payments. Notional values are generally standardized into denominations of $1 million. However, capital market transactions can use their own nonstandard notional values.

There are certain derivatives in which the notional value is not fixed—it declines over time. This is where the derivative is linked with an amortizing loan or an asset-backed security where the underlying asset pool consists of amortizing assets.

The premium is the consideration for purchasing protection that the protection buyer pays to the protection seller over time. The premium is normally expressed in terms of basis points (bps). For example, a premium of 85 bps means on a notional value of $1 million the protection buyer will pay to the protection seller $8,500 as the annual premium. The premium is normally settled on a quarterly basis but typically accrues on a daily basis.

The premium may not be constant over time—there might be a step-up feature, meaning the premium increases after a certain date. This might be either to reflect the term structure of credit risk or simply for a perfunctory regulatory compliance as discussed next.

The tenure is the term over which the derivative deal will run. The tenure comes to an end either by the efflux of time or upon happening of the credit event, whichever is earlier. For portfolio derivatives, the credit event on one of the obligors may not lead to termination of the derivative. As we discussed earlier, the tenure of the credit derivative need not coincide with the maturity of the actual exposure of the protection buyer. However, for regulatory purposes, conditions for capital relief curtail the benefit of capital relief where there is a maturity mismatch between the tenure of the underlying credit asset and that of the credit derivative. So, the common practice in transactions where the protection buyer intends to seek a capital relief, but where the protection seller wants to give protection for only three years while the underlying exposure is for five years, is to quote a rate for three years, with a step-up after year 3, with an option to terminate with the protection buyer. The protection buyer will terminate the transaction due to the step-up feature, effectively getting protection only for three years, while theoretically, for regulatory purposes, the exposure is fully covered for five years.

If a credit event takes place, the protection seller must make compensatory loss payments to the protection buyer, as in case of a standard insurance contract. However, the significant difference between a standard insurance contract and a credit derivative is that for the latter, it is not important that the protection buyer must actually suffer losses; nor is the amount of actual loss relevant. Losses of the protection seller are also known as the protection payment.

The loss computation and the payments required to be made by the protection seller are a part of the "settlement" of the contract. Obviously, the losses of the protection seller will depend on the settlement method—physical or cash. Where the terms of settlement are cash, the contract will provide for the manner of computing losses. Here, the loss is the difference between the par value of the reference asset (that is, the notional value plus accrued interest, as per terms of the credit), less the fair value on the valuation date. Most of the reference assets will not have any deterministic market values as such. Consequently, the method of computing the fair value is described in the contract in details. If the reference asset is something like a senior unsecured loan, the market value may be determined by taking an average of the quotes given by several independent dealers. Typically, the quotes are taken on more than one date, and, therefore, there are various valuation methods applicable, such as highest or average highest.

As significant as specifying the valuation method is the specification of the valuation date. Usually, a cooling-off period is allowed between the actual date of happening of an event of default and the valuation date. This is to allow for the knee-jerk reaction of the market values to be mitigated and more rational pricing of the defaulted credit asset to take place.

Computation of losses is not required for a type of derivative called binary swaps or fixed recovery swaps, where the protection seller is required to pay a particular amount to the protection buyer, irrespective of the actual losses or valuation.

Credit derivative contracts may sometimes provide for a threshold risk, up to which the losses will be borne by the protection buyer, and it is only when the losses exceed the threshold limit that a claim will lie against the protection seller. This is also called a materiality loss provision, under the understanding that only material losses will be transferred to the protection seller, even though the threshold limit may be quite high and not necessarily prevent immaterial losses from being claimed from the protection seller. In such cases, the more appropriate term is first loss risk, where the first loss risk up to the specified amount is borne by the protection buyer and it is only losses above the first loss amount that are transferred to the protection seller.

Settlement arises when the credit events take place. The terms of settlement could be either cash settlement or physical settlement. In the case of cash settlement, the losses computed as discussed above are paid by the protection seller to the protection buyer, and there is no transfer of the reference asset by the protection buyer. With physical settlement, the protection buyer physically delivers, that is, transfers an asset of the reference entity that satisfies the criteria for a deliverable obligation, and gets paid the par value of the delivered asset, limited, of course, to the notional value of the transaction. The concept of deliverable obligation in a credit derivative is critical, as the derivative is not necessarily connected with a particular loan or bond. Being a transaction linked with generic default risk, the protection buyer may deliver any of the defaulted obligations of the reference entity. However, to prevent against something like equity or other contingent securities from being delivered, transaction documents typically specify the characteristics of the deliverable obligations.

The general belief in the credit derivatives market is that losses of the protection seller are less in the case of a physical settlement than in the case of cash. This belief is quite logical, since the quotes in the case of a cash settlement are made by potential buyers of defaulted assets, who also hope to make a profit in buying the defaulted asset.

Physical settlement is more common where the counterparty is a bank or financial intermediary who can hold and take the defaulted asset through the bankruptcy process or resolve the defaulted asset. Physical settlement is, however, quite problematic where there are plenty of outstanding transactions referenced to an entity. This situation is almost certain to arise in the case of entities included in popular indices. When several protection buyers scout the market for buying defaulted assets, there might be a short squeeze in the market and an artificial inflation in the price of the defaulted security. In appreciation of these difficulties, the market has of late started moving in the direction of cash settlements or fixed recovery trades.

A credit default swap can literally be defined as an option to swap a credit asset for cash, should it default. A credit default swap is essentially an option bought by the protection buyer and written by the protection seller. The strike price of the option is the par value of the reference asset. Unlike a capital market option, the option under a credit default swap can be exercised only when a credit event takes place.

In a credit default swap, if a credit event takes place, the protection buyer at his option may swap the reference asset or any other deliverable obligation of the reference obligor, either for cash equal to the par value of the reference asset, or get compensated to the extent of the difference between the par value and market value of the reference asset.

Credit default swaps are the most important type of credit derivative in use in the market.

A credit default swap protects the protection buyer against losses when a credit event happens. However, a credit event is a rare event. The holder of a credit asset is not merely concerned with losses in the event of default, but mark-to-market losses, since the latter is more frequent. A credit asset might continue to give mark-to-market losses for quite some time before it actually ripens into a default.

As the name implies, a total-rate-of-return swap or total return swap is a swap of the total return out of a credit asset swapped against a contracted prefixed return. The idea in a total-rate-of-return swap is to protect the protection buyer against mark-to-market losses as well; hence, the parties swap the total return from the reference credit asset or pool of assets. The total return out of a credit asset is reflected by the actual earnings realized from the reference asset plus the actual appreciation/depreciation in its price over time. The total returns from a credit asset may be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements. Nevertheless, the protection seller in a total return swap guarantees a prefixed spread to the protection buyer, who in turn agrees to pass on the actual collections and actual variations in prices on the credit asset to the protection seller.

So periodically, the protection buyer swaps (the actual return on a notional value of the reference asset), in lieu of (a certain spread on a reference rate, say, LIBOR + 60 bps).

A credit-linked note (CLN) is a securitized form of credit derivative that converts a credit derivative into a funded form. Here, the protection buyer issues notes or bonds that implicitly carry a credit derivative. The buyer of the CLN sells protection and prefunds the protection sold by way of subscribing to the CLN. Should there be a credit event payment due from the protection seller, the amounts due on the notes/bonds on account of credit events will be appropriated against the same, and the net, if any, will be paid to the CLN holder. A CLN carries a coupon which represents the interest on the funding and the credit risk premium on the protection sold, that is to say, the protection inherently sold via the CLN is compensated in the form of the coupon on the CLN. Obviously, the maximum amount of protection that the CLN holder provides is the amount of principal invested in the CLN.

A credit spread option is basically a call or put option on an asset exercisable based on a certain spread. The call or put is an option with the holder, who is the protection buyer. Let us say a protection buyer agrees with the protection buyer that should the spread of a particular bond exceed a particular spread over LIBOR (referred to as the strike spread), then the protection buyer will have the option, as usual, of either a physical settlement of the reference obligation at the strike spread, or net settlement.

The option to put the asset can be said to be the option to call a predetermined spread. In other words, the protection buyer intends to protect a particular spread over a base rate and indicates a negative view on the reference obligation. On the contrary, if the protection buyer holds a positive view on the reference obligation, he may enter into an option to call the asset or put the spread.

Credit spread options are not related to events of default as, understandably, the movement in spreads can be related to various factors besides credit events.

In regulatory standards of most countries, credit spread options are not considered for regulatory capital relief. See, for example, paragraph 8.2.1 of FSA, the United Kingdom's regulatory requirements on credit derivatives state that "protection bought using a credit spread option is ignored for capital purposes." That they are not eligible for regulatory capital relief is a major reason why spread options have not become as popular as the other types of credit derivatives.

The traditional guarantee contract provides for payment by the guarantor to the creditor in case of a default by the debtor. Credit derivatives, particularly credit default swaps, might have an apparent similarity with traditional guarantees. However, the similarity goes no further.

In a traditional guarantee, the intent of the guarantor is to protect the creditor from losses and put the creditor at par with what would have been received had the original debtor not defaulted. Thus, the payments by a guarantor are typically due only:

Credit default swaps, however, are not limited to "default" as such but generally extend to cover events such as bankruptcy, compromise, and restructuring. Besides, for credit default swaps, the payments to be made by the protection seller might be either a prefixed amount or based on a valuation, which may or may not equal to the damage suffered by the protection buyer.

Another significant difference lies in the fact that a guarantee is always a trilateral contract: the guarantor, debtor, and creditor are all parties to the contract of guarantee. Credit default swaps, however, are purely a contract between the protection buyer and seller, and the obligor may not come to know about the contract at all.

The differences between traditional guarantees and credit derivatives are summarized in Table 42.1.