Markets - Derivatives - Examples - Credit - Derivatives - Types: CDS, CDOs - CLN - TRS

http://www.1mtx.com/markets-trades/en/index.php?language=en&menu=MARKETS&punkt=Derivatives&punkt2=Examples&index=Credit#ExamplesCredit Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, options and swaps. Derivatives Markets - Examples Credit Derivatives Credit Derivative: a financial instrument designed to transfer credit risk from one party to another; a derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded. Credit default products are the most commonly traded credit derivative products and include unfunded products (e.g. CDS - Credit Default Swaps) and funded products (e.g. CDOs - Collateralized Debt Obligations). Latest Updates... Daily Updated: ? Selected Interest Rates (Fed. funds - Commercials - CDs - Eurodollar deposits - Bank prime loan - U.S. governm. securities - Interest rate swaps - > U.S. Fed. Reserve) Latest Updates... Market Size and Participants The ISDA reported in April 2007 that total notional amount on outstanding credit derivatives was $ 35.1 trillion with a gross market value of $ 948 billion. »...ISDA International Swaps and Derivatives Assoc. (website) »...Wholesale Trading Facilities (EUREX website) The credit derivatives market is a global one, however London’s market share rests at around 40 per cent, with the rest value of Europe standing at about 10 per cent. The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against certain pre-agreed events occurring in relation to a third party (usually a corporate or sovereign) known as a reference entity; which affect the creditworthiness of that reference entity. The reference entity will not (except in certain very limited circumstances) be a party to the credit derivatives contract, and will usually be unaware of the contract's existence. " ...1981 - Product innovation accelerates with the first interest rate swaps, currency swaps... 1995 - First Credit Default Swaps (CDS) and Collaterized Debt Obligation (CDO) ..." »...History of Credit Derivatives (Financial-edu.com) Unfunded and Funded: Types of Credit Derivatives Unfunded credit derivative products: An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. ? Total return swap (TRS) ? Single name Credit default swap (CDS) ? First to Default Credit Default Swap ? Portfolio Credit Default Swap ? Secured Loan Credit Default Swap ? Credit Default Swap on Asset Backed Securities ? Credit default swaption (CDS) ? Recovery lock transaction ? Credit Spread Option ? CDS index products ? Constant Maturid Credit Default Swap (CMCDS) In a Funded credit derivative, the credit derivative will be embedded into a bond (usually either issued by an SPV* or a financial institution), and bondholders will (ultimately) be responsible for the payment of any cash or physical settlement amounts. ? Credit linked note (CLN) ? Synthetic Collateralised Debt Obligation (CDO) ? Constant Proportion Debt Obligation (CPDO) ? Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI) *SPV : Special purpose vehicle (or special purpose entity), a company created to meet a specific need. Credit linked notes (CLN) A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider. It is issued by a special purpose company or trust, designed to offer investors par value at maturity unless a referenced credit defaults. In the case of default, the investors receive a recovery rate. The trust will also have entered into a default swap with a dealer. In case of default, the trust will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed on to the investors in the form of a higher yield on their note. The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available. The CLNs themselves are typically backed by very highly-rated collateral, such as U.S. Treasury securities. »...more (Credit linked notes) Collateralized debt obligations (CDO) Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche. In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO. Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared. »...more (Types of CDOs) ...Chicago is home to four major financial and futures exchanges, including the Chicago Stock Exchange, the Chicago Board of Trade (CBOT), the Chicago Board Options Exchange (CBOE), and the Chicago Mercantile Exchange (the Merc)... City of Chicago/IL (USA) ADVERTISEMENT Chicago is home to four major financial and futures exchanges, including the Chicago Stock Exchange, the Chicago Board of Trade (CBOT), the Chicago Board Options Exchange (CBOE), and the Chicago Mercantile Exchange (the "Merc"). »...CBOE (website) » Derivatives Types » Swaps » Types of swaps Credit default swap Uses: Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity. Credit default swaps (CDS) are bilateral contracts under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). »...more (Structure and features) Total return swap Uses: Hedge funds are using them to obtain leverage on the Reference Assets: they can receive the return of the asset, typically from a bank without having to put out the cash to buy the Asset. Total return swap (TRS - also known as total rate of return swap, or TRORS) is a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness of the reference asset, especially where the payments are based on the same notional amount. The reference asset may be any asset, index, or basket of assets. »...more (Financial-edu - website) Risks Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. ADVERTISEMENT Swaps (March 1, 1952 - November, 1972) was a California bred American thoroughbred racehorse. He was the son of Khaled, a stallion imported from the Aga Khan's stud in Europe. Swaps goes back to the immortal Man o' War, via his dam, Iron Reward, through the Triple Crown winner, War Admiral. In the list of the top 100 U.S. thoroughbred champions of the 20th Century by Blood-Horse magazine, Swaps ranks 20th. In articles and books on the subject, there are those who strongly believe that rank is too low. »...Swaps Derby Take a break... 'Mike Gasior - Credit Default Swaps' 'Swaps - 1955 Kentucky Derby Recap' ...just relax... The "loan only" credit default swap (LCDS) A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely traded LCDS form which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same as that which has been used in the various ISDA cash settlement auction protocols but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. Quarterly Derivatives Fact Sheet (The Office of the Comptroller of the Currency (OCC) - website) | Reports | Analysis | Opinions | Comments | "...we continue to look at an alphabet soup of problems: RMBSs, CDOs, Alt-A, BBB and - a new acronym to put on your radar screen - the very useful CDS. When does an AAA rating not mean an offering is ready for prime time?..." Read more...» Where is the Real Risk in the Subprime Debacle? (by John Mauldin 07/06/2007 - Safehaven) "...Wildness Lies in Wait " The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. "It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait." - G. K. Chesterton All of the subprime mortgages and CDOs that sit on the books of banks throughout the world are the wildness that lies in wait. We can know with some exactitude that there are going to be $100 billion in losses, give or take. What we cannot know is from what hidden glen the losses will spring up. Where is this paper?..." Read more...» Sea Change at the Fed (by John Mauldin 09/22/2007 - Safehaven) ^ top Sources: Wikipedia.org; Safehaven.com; Financial-edu.com; .1MTX 2007/2008