Introduction to main credit derivatives

Currently, credit derivatives use three basic construction methods: forward contracts, swaps and options. According to the different pertinence of credit derivatives, they can be divided into three categories: Total-return Swap, Credit-spread Products and Credit-default Products. ).

1． Total return swaps

Total return swaps are sometimes called loan swaps (Loanswaps) or credit swaps (Credit swaps). Their main function is to replicate the overall performance of a credit asset.

In a total return swap, investors accept all risks and cash flows (including interest and fees, etc.) of loans or securities (generally bonds) that originally belonged to the bank, and at the same time pay the bank a certain The income (such as LIBOR shown in the figure) will generally add or subtract a certain interest rate difference based on LIBOR. Different from general swaps, in addition to exchanging cash flows during the swap period, banks and investors also need to settle the price difference of the loan or bond when the loan matures or defaults. The calculation formula is determined in advance at the time of signing. If the market price of the loan or bond appreciates by then, the bank will pay the price difference to the investor; conversely, if there is an impairment, the investor will pay the price difference to the bank. Sometimes the price difference is also settled each time the parties swap payments. Total return swaps generally have maturities of 1 to 5 years, with 3 to 5 years being the most common.

2. Credit spread products

Credit spread products are used to compensate investors for the default risk of underlying assets. The formula for calculating the interest rate spread above the risk-free interest rate is: credit spread = income from loan or security - income from the corresponding risk-free security. Credit spread products include spread forwards and spread options.

Interest spread forward is similar to a forward interest rate agreement. The bank and the investor agree on a forward interest spread (the spread is based on a risk-free asset or a reference asset). In actual application, Generally, the absolute yield is not used as the price target, but the interest rate difference with the yield of a specific government bond is used as the price target. On the maturity date, the two parties will settle the difference based on the actual interest difference and the interest difference agreed upon at the time of signing. If the actual interest spread is higher than the agreed interest spread, the bank will pay the investor the difference; otherwise, the investor will compensate the bank. The calculation formula for the specific amount is: settlement amount = (interest spread agreed in the forward agreement - actual interest spread on the maturity date) * holding period * principal.

The spread option allows the buyer of the agreement to unilaterally choose to pay or not pay the spread at expiration. Just like regular options, spread options are divided into call options and put options. The buyer of a call option has the right to buy the spread and make a profit if the spread falls; conversely, the buyer of a put option has the right to sell the spread and make a profit if the spread rises.

3 Credit default products

Credit default products are credit derivatives specifically targeting default risk. There are two types of credit default products. One is for the default of individual assets, mainly credit default options or default puts. Since this product is similar to a swap, it is also called a credit default swap. The other is a default index product, which targets systemic default risk.

In the case of a default put, the buyer (the bank seeking protection) pays a periodic option premium to the seller (the bank providing protection), and the seller therefore bears the default risk of the reference asset. If a pre-agreed event of default occurs during the validity period of the option, the seller will provide a default payment to the buyer.

Default index products appeared later. In November 1998, the Chicago Board of Trade (CME) introduced the first exchange-traded credit derivative contract, the Quarterly Bankruptcy Index Derivative. The listing of this product marked the official entry of credit derivatives into exchange trading. This index product primarily serves banks and consumer lenders, especially credit card companies. The contract method can be futures or options, but they are all based on the CME Quarterly Bankruptcy Index (CME QBI), which is equal to the number of newly registered bankruptcies in the United States three months before the contract expiration date.

This index transaction provides a tool to prevent systemic credit risks, especially for banks and consumer credit institutions to manage the portfolio of credit assets. By purchasing default index product contracts, you can effectively prevent the system from increasing bankruptcy rates due to economic downturns. Credit risk. The bank that purchased the contract will be compensated if the QBI on the expiration date is higher than the index at the time the contract was entered into. The contract amount is equal to $1,000 multiplied by the index.