Any commercial lender in the world has to face
credit risk, or in other words, the risk of default
on repayment of obligations. In order to counteract
credit risk, credit default swaps were introduced in
the market, which enabled lenders to transfer their
credit risk and return from an underlying asset to
another party, without the actual transfer of the
ownership of the underlying asset.
Credit Default Swaps (CDS) have become a
huge success and have grown to a whopping
$ 4.5 tn by June 2004 and are poised to grow even
further in the coming years.
Credit Default Swaps Explained
A credit default swap is a guarantee contract that
can protect the lender against certain
pre-determined credit losses involving a reference underlying asset. There are two parties in a CDS
namely the credit protection buyer and the credit protection seller. A credit protection buyer pays the
credit protection seller a fee throughout the life of the contract, in exchange for protection in case a
credit default event takes place. The amount that the guarantor has to pay the beneficiary in case the
unfortunate event takes place will be the difference between the original value of the asset and the
amount recovered on it, or in other words, the amount that the beneficiary has lost due to the credit
default. The default protection can be created for a loan and its interest payments, bond, or any other
financial asset that entails the payment from one party to the other.
It is difficult to find a seller of protection for each and every type of exposure one has in the balance
sheet. Guarantors look forward to underlying assets in which they feel there will be no loss or where
the amount of recovery is the maximum, or in other words, where the borrower has a good
creditworthiness. The risks of the seller of protection are immense, just like those of a writer of a call
option. If the borrower of the loan starts sliding towards default, the guarantor (seller of protection) can
only start providing for the expected losses, unless there is a liquid secondary market in which the
protection seller can offload his holdings. Till now, needless to say, the protection buyer had to find a
counterparty (seller of protection) and this was not easy to do.
First Exchange Listed Credit Default Swaps
In order to overcome the problems faced by protection buyers (lenders) of finding a suitable protection
seller, Eurex Exchange has tied up with IIC (International Index Company) in order to list an exchange
traded credit derivative product based on ITraxx’s European CDS index, which is based on 125 CDS
of the most liquid investment grade companies in Europe (See Exhibit A).
The product will be available by the end of 2005 and will enable protection buyers and sellers to
hedge their positions without the hassle of finding a counterparty or having to write off expected
losses. |
