What are derivatives?

A derivative is a contract between two parties that specifies the terms of a future transaction between them. The transaction involved may be the sale or purchase of an asset or a cash payment that is triggered by an event. A simple example of a derivative is a bet between two parties on the level of the Dow Jones Industrial Average on the 15th of January next year.

The value of a derivatives contract depends upon the likelihood of the future transaction and the level of the underlying price/index that is involved in the future transaction. Thus in the case of a bet on the Dow Jones, the value of the contract moves up and down with the level of that index.

The main reason that companies enter into derivatives contracts is to manage their financial exposures: either to reduce existing exposures or to create new ones.

For example, say a company has an existing variable rate loan. This loan exposes it to the risk of a rise in interest rates, which would increase its interest expense. If the company is worried about this exposure it could fix the rate on the loan by entering into an interest rate swap (a type of derivative contract) with a bank.

In this derivative contract the company would pay a fixed coupon and receive a variable coupon. The variable coupon from the derivative contract offsets the variable interest due on the loan, leaving the company paying a fixed rate of interest.

There are two fundamental types of derivatives contracts: forwards and options. These contracts act as building blocks for a variety of derivatives.

A forward is a derivatives contract in which two parties agree to conduct a financial transaction at a future date. The contract’s terms and conditions are specified at its inception, and both parties are obliged to carry out their part of the transaction.

An option is a derivatives contract between two parties that gives one of them the right to demand a financial transaction from the other party on a future date. If the transaction involves the purchase of an asset, the contract is called a call option. If it involves the sale of an asset, it is called a put option.

What are swaps?

A swap is a derivative contract that involves the exchange of one or more cash flows in the future between the parties. Some of these cash flows may be fixed whilst others are calculated on the basis of the price of either an underlying asset or commodity, or a market rate or index (e.g. LIBOR, STOXX, etc.).

A swap contract is effectively composed of one or more forwards and its value is dependent upon the price of the underlying asset or a market index.

Companies and financial institutions enter into swaps to manage their existing market risk and credit risk. For example, a company could enter into an interest rate swap to fix the interest rate on its loan. Similarly, it could enter into a bankruptcy swap to protect itself against the risk of default by a debtor.

What are credit derivatives?

A credit derivative is a contract between two parties, which agree to a future transaction based on the occurrence of a credit event, i.e. default or bankruptcy by a third party (referred to as the Reference Entity). Credit derivatives are essentially designed to protect one of the signing parties against the risk of default by the Reference Entity. The party seeking the protection is called the Protection Buyer and the party providing the protection is called the Protection Seller.

There are many different types of credit derivative contracts. Most of them involve a fixed payment by the Protection Buyer to the Protection Seller. In return the Protection Buyer receives a payment that is contingent upon:

• the bankruptcy by the Reference Entity,
• a default by the Reference Entity, or
• a change in the credit quality, as measured by a credit rating or a yield spread over a "risk-free" benchmark such as Treasury bonds, LIBOR, etc.

The counter-parties enter into a credit derivative contract for two reasons:

• to manage the risk of default by buying some form of protection
• to earn income by selling the protection against the risk of default

Managing exposure using credit derivatives

Suppose that a company is exposed to credit risk due to a debt, a loan, a trade note or some financial contract, and they need to reduce this exposure. This can be achieved by immediately settling the contract with the concerned party if possible, or by selling the loan or trade note in the market (to a factoring company for example).

In many cases though, neither of these alternatives may be appropriate due to the adverse effect on client relationship, or the heavy discount applied by the factoring companies that purchase the debt. In the case of derivative contracts, there may even be accounting or tax considerations, which prohibit immediate settlement or sale.

In such cases, companies can reduce the credit risk while keeping the original debt on their books by buying credit derivatives. Credit derivatives are private (and hence confidential) contracts that allow companies to purchase credit protection in a flexible way. This makes them more appealing than the alternatives above.

The flexibility of credit derivatives and the fact that they can be bought and sold in the market also makes them more attractive than credit insurance.

For example, say a company has a large concentration of credit exposure to a particular client and wants to reduce this to a more manageable level. Now it may be that the cost of purchasing the required protection is prohibitively expensive. In which case the company could buy a bankruptcy swap (a type of credit derivative) for the existing exposure and pay for it by selling a bankruptcy swap on another Reference Entity to which it has no existing exposure.

In this way, the company can transfer some of its credit exposure from one Reference Entity to another and reduce any concentration of credit risk in its books.

Earning income from credit derivatives

Credit derivatives provide a means of earning an income without requiring large initial cash outlays. This is a big advantage for investors (mostly banks and financial institutions) that face a relatively high cost of capital.

However, selling credit derivatives purely for generating income is not recommended for companies. These are highly leveraged contracts, and in the worst case can lead to heavy losses for the seller.

The instance where it may be appropriate for a company to sell credit derivatives is when transferring credit exposure from one Reference Entity to another, i.e. selling credit derivatives on one Reference Entity to subsidise the purchase of credit protection on another Reference Entity.

What is a bankruptcy swap?

A bankruptcy swap is a derivative contract that allows a creditor to buy protection against bankruptcy by a debtor.

The Buyer of the contract (the Protection Buyer) pays a periodic fee to the Seller (the Protection Seller). In return the Buyer receives a payoff equal to the notional amount of the contract upon the occurrence of a Credit Event, i.e. bankruptcy by the Reference Entity.

The fee paid by the Buyer is typically expressed as basis points. This is multiplied by the notional amount of the contract to calculate the dollar value of the payment.

Definitions used in contracts

• Buyer- the counter-party buying the credit protection
• Seller- the counter-party selling the credit protection
• Reference Entity- a company or financial institution specified in the contract
• Credit Event- bankruptcy by the Reference Entity
• Payoff- payment of the notional amount made by the seller to the buyer upon occurrence of the Credit Event

Rationale for Protection buyer

Buyers of bankruptcy swaps are usually companies that wish to reduce the credit exposure to their clients. Bankruptcy swaps allow the companies to reduce credit exposure concentrations and dynamically manage the credit risk of the portfolio.

Given that bankruptcy swaps are confidential contracts, they allow companies to reduce credit exposure without affecting client relationships. By freeing up existing exposure in this way, companies can engage in even more business with the given clients.

Note: the bankruptcy swap specifically provides protection against the risk of bankruptcy. Financial institutions often use a variant of this swap, called the credit default swap, which provides protection against the incidence of default.

Rationale for Protection seller

Companies can earn an income by selling bankruptcy swaps and assuming credit exposure to a Reference Entity. This may seem to be especially attractive since this does not require a substantial capital outlay, but is not recommended as an investment strategy.

Selling bankruptcy swaps is recommended in the following cases:

• the sale offsets an earlier position created by buying a bankruptcy swap
• the sale is being used to subsidise the purchase of another bankruptcy swap
• the sale is a part of an overall strategy to optimise the company's credit portfolio

For example, consider a company that has a large concentration of credit risk to a single Reference Entity X. The company has the capacity to take the amount of credit exposure but wants to reduce its dependence on Entity X. Moreover, the company does not wish to pay cash for credit protection.

So the company purchases a bankruptcy swap for protection against Reference Entity X, and offsets the purchase cost by selling a bankruptcy swap for protection against another Reference Entity Y. This reduces the credit concentration and makes the credit portfolio more diversified.

What is a credit swap?

A credit swap (or a credit default swap) is a credit derivative contract similar to the bankruptcy swap. As in the case of the bankruptcy swap, the Buyer pays a periodic fee to the Seller and in return receives a Payoff upon the occurrence of a Credit Event.

The credit swap differs from the bankruptcy swap in two ways:

• the Credit Event that triggers the contingent Payoff is the default by the Reference Entity (rather than bankruptcy) and
• the Payoff is a portion of the notional amount based on the Recovery Rate assumed in the contract rather than the full notional amount of the contract

Credit default swaps are popular with financial institutions, which are sensitive to the incidence of default on loans, bonds or derivatives contracts. In contrast, companies prefer bankruptcy swaps as they need protection specifically against the event of bankruptcy by a debtor. In such cases a credit default swap may be inappropriate as it is triggered by a technical default, which may be of less consequence to the company.

What is the most appropriate credit derivative instrument for hedging trade credit exposures?

One of the principle differences between a Bankruptcy Swap and a Credit Swap (both discussed in earlier sections) is the Credit Event that triggers a payment to the swap buyer.

Under a Bankruptcy Swap the buyer will receive payment upon the bankruptcy of the Reference Credit, whereas under a Credit Swap the buyer will receive a payment if the Reference Credit defaults on its bond covenants.

When a company extends trade credit its principal concern is whether the trade counterparty will honour its payment obligations to them. Consequently they will only worry if their trade counterparty breaches a bond covenant if this also means that the counterparty will not be able to meet its trading obligations.

This is sometimes the case. However, in many instances, when a company defaults on its bonds, it will continue to meet its trade obligations. This is because bond holders and other lenders will want to keep the company alive as a going concern. They will only push a company into bankruptcy as a last resort, because they know that keeping it alive will give them a much better chance of getting full repayment of their loan.

If a company remains in business, it will continue to honour its trade obligations. Consequently the risk that it will fail to honour its trade obligations is much more closely associated with bankruptcy than with bond default, which makes the Bankruptcy Swap a much more appropriate instrument to hedge trade credit than a Credit Swap. (Credit Swaps are of course very appropriate hedging instruments for financial institutions who do need to hedge against default risk).