Credit Derivatives - Default Swaps and Default Options

A credit derivative is, as its name suggests, a contract between two ( or, very rarely, more than two ) parties, the value of which is derived from that of some other financial contract or instrument whose value is sensitive to the creditworthiness or credit-related behaviour of one or more
corporations or governmental agencies. The principal use of credit derivatives is in the assumption of, or laying off of, credit risk. Credit derivatives allow the independent transfer of a specific category of risk; in this, they are similar to all other derivatives.

Credit derivatives allow the transfer of credit risk, by which we mean the risk that an entity may fail to meet its contractual obligations to make payment on some other instrument or contract. Credit derivatives result from the extension of techniques already well-established in other financial derivatives markets. The value of credit derivatives is that they permit the user to trade and manage credit risk independently of other kinds of risk. That is, credit derivatives provide previously undeveloped ways of hedging and investing in the credit markets.

Default Swaps

The simplest kind of credit derivative is the default swap. Default swaps are contracts between two counterparties, which allow the parties to transfer the credit risk associated with some reference asset without also transferring ownership of the asset itself. A typical default swap has the following structure:

At the beginning of the deal, the two counterparties nominate a reference asset ( typically a bond ) issued by some borrower in the international capital markets. Counterparty A is the "protection seller" and Counterparty B is the "protection buyer" or "hedger". Under the terms of the default swap contract, Counterparty B pays a regular fixed payment to Counterparty A. This can be thought of as similar to an insurance premium: in return for paying a regular fee, Counterparty B buys protection against a default by the nominated borrower on the designated reference asset. If the designated borrower does not default on the reference asset, Counterparty B receives nothing in return for the periodic payments it has made over the term of the default swap. If, however, the designated borrower does default on the reference asset during the term of the contract, Counterparty A makes a one-off payment to Counterparty B; typically this payment is calculated on the basis of the reduction in market value of the reference asset due to the default, this being determined by reference to some pre-agreed formula.

To make this clearer, it may be helpful to consider a typical deal. Here are some possible terms for a default swap:

The effect of this default swap is to transfer credit risk from Counterparty B to Counterparty A for the five year period starting on 10 December 1999. During that time, Counterparty B will make a payment of $3,500 every six months to Counterparty A. In return for this, Counterparty A agrees to provide protection on the credit risk. As long as XYZ Corporation meets all the payments it is due to make on its bonds, Counterparty A does nothing. If, however, XYZ Corporation fails to make an interest payment on its 8% bonds of 2019, or it proposes to redeem these bonds early and then fails to repay the principal appropriately, Counterparty A will make a single payment to Counterparty B.

This payment will be determined from the market value of the bonds after the default has occurred. If XYZ Corporation defaults, the value of its outstanding bonds will fall sharply. Typically, the bonds will not lose all their value: even after the corporation has defaulted on its debt, it will still have some funds, and perhaps some sellable assets, which means that some of the money that it has borrowed can be repaid to its bondholders. Suppose that the market values the bonds at a price of 20 five business days after the default ( this is equivalent to saying that the market expects XYZ Corporation's debt to be repaid at 20 cents on the dollar ): then Counterparty A will pay Counterparty B a total of $8,000,000, five days after XYZ Corporation has defaulted. The economic effect of this payment is to compensate Counterparty B for the loss due to holding the XYZ Corporation bonds at the time of the default. ( Before the default, Counterparty B had investments in XYZ Corporation worth $10,000,000; after the default, the bonds are worth $2,000,000, and the payment from Counterparty A of $8,000,000 brings the total value of Counterparty B's assets up to $10,000,000 again. )

Notice that if XYZ Corporation defaults after 10 December 2004, Counterparty B has no recourse to any protection from Counterparty A. Note, also, that if XYZ Corporation defaults on some other bonds or other financial liabilities, Counterparty B has no protection, unless XYZ Corporation's obligations are linked together by some form of cross-default clause in their documentation.

If Counterparty B holds $10,000,000 of the XYZ Corporation 8% bonds of 2019, it is hedged against the possibility of a default by XYZ for five years. It is thus easy to see why Counterparty B is called the "protection buyer" or, sometimes, the "risk seller". What is slightly less obvious is that it is not actually necessary for Counterparty B to own any of these bonds at any time during the duration of the contract. For example, Counterparty B could own $10,000,000 of some other bonds issued by XYZ Corporation; the default swap contract would in that case provide protection in the event of default precisely as far as the behaviour of the bonds actually held by Counterparty B mirrored the behaviour of the nominated bonds under these adverse circumstances. Alternatively, Counterparty B might own bonds issued not by XYZ Corporation, but by its rival, UVW Company; in this case, the hedge provided to Counterparty B for its credit exposure ( which in this case would be to the UVW Company ) would be exactly as good as the correlation between the behaviour of the two companies: if the UVW Company is likely to go broke at the same time as the XYZ Corporation, the hedge would be good, but if the relationship between the behaviour of the two is not good, the usefulness of the default swap contract as a hedge would be similarly poor. Finally, of course, Counterparty B might own no relevant bonds at all; in that case, B is speculating on the creditworthiness of XYZ Corporation, in much the same way that opening a short position in the Reference Asset would, but without taking the interest rate risk that running such a short would entail, and without incurring the administrative costs that would arise in this kind of deal.

Counterparty A has used this deal to take a risk position in XYZ Corporation. In many ways, the risk that it has taken is the same as that which would arise by buying the relevant 8% bonds of 2019, and immunising the interest rate exposure that would arise from such a purpose. Counterparty A has, however, taken this credit risk only for the lifetime of the default swap contract; this risk is effectively limited in time, though, since in effect Counterparty A has entered into a deal under which it returns the credit risk to Counterparty B on the 10 December 2004 at a pre-agreed price. In a sense, then, Counterparty A, sometimes known as the "protection seller", can also be thought of as the "risk buyer", with the risk being taken as what is effectively a synthetic immunised bond of five years' duration.

When we consider what the two counterparties get out of entering into a default swap, it is easy to see why these contracts are so popular. Each counterparty gets something which it might not otherwise be able to obtain - protection in the case of Counterparty B, and access to a potentially interesting asset in the case of Counterparty A - in a way which is comparatively quick to execute and easy to administer, and which can be governed by documentation and back-office skills already comparatively well-developed from other derivatives trading activities. It is no surprise to discover that default swaps are amongst the most popular and widely traded of all credit derivatives.

Default Options

Default options are closely linked to default swaps. Indeed, the linkage between default swaps and default options is so close that some market practitioners make no distinction between the two. There is, however, an important but subtle difference between the two.

Structurally, default options look very similar to default swaps:

Just as with a default swap, Counterparty A is the "protection seller", and Counterparty B is the "protection buyer", and, just as with a default swap, at the beginning of the deal, the two counterparties nominate a reference asset ( typically a bond ) issued by some borrower in the international capital markets. Under the terms of the default option contract, Counterparty B makes a payment to Counterparty A. This payment may be a single, one-off payment at the beginning of the deal, just like the payment of any other option premium, or may be broken into a series of payments made over the term of the contract. This can be thought of as similar to any other option premium: in return for paying this premium, Counterparty B buys protection against a default by the nominated borrower on the designated reference asset. If the designated borrower does not default on the reference asset, Counterparty B receives nothing in return for the premium paid to Counterparty A. If, however, the designated borrower does default on the reference asset during the term of the contract, Counterparty A makes a one-off payment to Counterparty B; this payment is calculated on the basis of the reduction in market value of the reference asset due to the default, and this is determined by reference to some pre-agreed formula, just as with a default swap.

To clearly understand the difference between a default swap and a default option, consider the following example terms for a default option:

At first sight, the terms of this default option look almost identical to the terms of the default swap discussed earlier. There is one difference, though: the payments that Counterparty B must make to Counterparty A. In the case of the default swap, Counterparty B's obligation to make payments terminates if XYZ Corporation defaults on its bonds, but in the case of the default option, Counterparty B must still make payments for the life of the contract. That is, Counterparty B's payments are fully known at the beginning of the deal.

An alternative, and more common, form for the default option is for the protection buyer's payment to be set as a single premium, payable to the protection seller at the beginning of the contract. As with the periodic approach, the protection buyer's payments are completely determined at the start of the deal. ( When we consider this approach to default options, it is easy to see how they get their name: just as with any other option, a premium is paid, in return for which the option buyer has the right to a benefit in the event of a certain market event. ) It is the certainty of the protection buyer's payments which distinguishes a default option from a default swap. In all other practical ways, the two kinds of credit derivative are indistinguishable.