Derivatives. Pirie Wendy L.

underlying reference security) and issues its own security (the credit-linked note) with the condition that if the bond or loan it holds defaults, the principal payoff on the credit-linked note is reduced accordingly. Thus, the buyer of the credit-linked note effectively insures the credit risk of the underlying reference security.

      These three types of credit derivatives have had limited success compared with the fourth type of credit derivative, the credit default swap (CDS). The credit default swap, in particular, has achieved much success by capturing many of the essential features of insurance while avoiding the high degree of consumer regulations that are typically associated with traditional insurance products.

      In a CDS, one party – the credit protection buyer, who is seeking credit protection against a third party – makes a series of regularly scheduled payments to the other party, the credit protection seller. The seller makes no payments until a credit event occurs. A declaration of bankruptcy is clearly a credit event, but there are other types of credit events, such as a failure to make a scheduled payment or an involuntary restructuring. The CDS contract specifies what constitutes a credit event, and the industry has a procedure for declaring credit events, though that does not guarantee the parties will not end up in court arguing over whether something was or was not a credit event.

      Formally, a credit default swap is defined as follows:

      A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.

      A CDS is conceptually a form of insurance. Sellers of CDSs, oftentimes banks or insurance companies, collect periodic payments and are required to pay out if a loss occurs from the default of a third party. These payouts could take the form of restitution of the defaulted amount or the party holding the defaulting asset could turn it over to the CDS seller and receive a fixed amount. The most common approach is for the payout to be determined by an auction to estimate the market value of the defaulting debt. Thus, CDSs effectively provide coverage against a loss in return for the protection buyer paying a premium to the protection seller, thereby taking the form of insurance against credit loss. Although insurance contracts have certain legal characteristics that are not found in credit default swaps, the two instruments serve similar purposes and operate in virtually the same way: payments made by one party in return for a promise to cover losses incurred by the other.

Exhibit 5 illustrates the typical use of a CDS by a lender. The lender is exposed to the risk of non-payment of principal and interest. The lender lays off this risk by purchasing a CDS from a CDS seller. The lender – now the CDS buyer – promises to make a series of periodic payments to the CDS seller, who then stands ready to compensate the CDS buyer for credit losses.

EXHIBIT 5 Using a Credit Default Swap to Hedge the Credit Risk of a Loan

      Clearly, the CDS seller is betting on the borrower’s not defaulting or – more generally, as insurance companies operate – that the total payouts it is responsible for are less than the total payments collected. Of course, most insurance companies are able to do this by having reliable actuarial statistics, diversifying their risk, and selling some of the risk to other insurance companies. Actuarial statistics are typically quite solid. Average claims for life, health, and casualty insurance are well documented, and insurers can normally set premiums to cover losses and operate at a reasonable profit. Although insurance companies try to manage some of their risks at the micro level (e.g., charging smokers more for life and health insurance), most of their risk management is at the macro level, wherein they attempt to make sure their risks are not concentrated. Thus, they avoid selling too much homeowners insurance to individuals in tornado-prone areas. If they have such an exposure, they can use the reinsurance market to sell some of the risk to other companies that are not overexposed to that risk. Insurance companies attempt to diversify their risks and rely on the principle of uncorrelated risks, which plays such an important role in portfolio management. A well-diversified insurance company, like a well-diversified portfolio, should be able to earn a return commensurate with its assumed risk in the long run.

      Credit default swaps should operate the same way. Sellers of CDSs should recognize when their credit risk is too concentrated. When that happens, they become buyers of CDSs from other parties or find other ways to lay off the risk. Unfortunately, during the financial crisis that began in 2007, many sellers of CDSs failed to recognize the high correlations among borrowers whose debt they had guaranteed. One well-known CDS seller, AIG, is a large and highly successful traditional insurance company that got into the business of selling CDSs. Many of these CDSs insured against mortgages. With the growth of the subprime mortgage market, many of these CDS-insured mortgages had a substantial amount of credit risk and were often poorly documented. AIG and many other CDS sellers were thus highly exposed to systemic credit contagion, a situation in which defaults in one area of an economy ripple into another, accompanied by bank weaknesses and failures, rapidly falling equity markets, rising credit risk premiums, and a general loss of confidence in the financial system and the economy. These presumably well-diversified risks guaranteed by CDS sellers, operating as though they were insurance companies, ultimately proved to be poorly diversified. Systemic financial risks can spread more rapidly than fire, health, and casualty risks. Virtually no other risks, except those originating from wars or epidemics, spread in the manner of systemic financial risks.

      Thus, to understand and appreciate the importance of the CDS market, it is necessary to recognize how that market can fail. The ability to separate and trade risks is a valuable one. Banks can continue to make loans to their customers, thereby satisfying the customers’ needs, while laying off the risk elsewhere. In short, parties not wanting to bear certain risks can sell them to parties wanting to assume certain risks. If all parties do their jobs correctly, the markets and the economy work more efficiently. If, as in the case of certain CDS sellers, not everyone does a good job of managing risk, there can be serious repercussions. In the case of AIG and some other companies, taxpayer bailouts were the ultimate price paid to keep these large institutions afloat so that they could continue to provide their other critical services to consumers. The rules proposed in the new OTC derivatives market regulations – which call for greater regulation and transparency of OTC derivatives and, in particular, CDSs – have important implications for the future of this market and these instruments.

      EXAMPLE 4 Options and Credit Derivatives

      1. An option provides which of the following?

      A. Either the right to buy or the right to sell an underlying

      B. The right to buy and sell, with the choice made at expiration

      C. The obligation to buy or sell, which can be converted into the right to buy or sell

      2. Which of the following is not a characteristic of a call option on a stock?

      A. A guarantee that the stock will increase

      B. A specified date on which the right to buy expires

      C. A fixed price at which the call holder can buy the stock

      3. A credit derivative is which of the following?

      A. A derivative in which the premium is obtained on credit

      B. A derivative in which the payoff is borrowed by the seller

      C. A derivative in which the seller provides protection to the buyer against credit loss from a third party

      Solution to 1: A is correct. An option is strictly the right to buy (a call) or the right to sell (a put). It does not provide both choices or the right to convert an obligation into a right.

      Solution to 2: A is correct. A call option on a stock provides no guarantee of any change in the stock price. It has an expiration date, and it provides for a fixed price at which the holder can exercise the option, thereby purchasing the stock.

      Solution to 3: C is correct. Credit derivatives provide a guarantee against