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WHAT ARE CREDIT DERIVATIVES? ''Credit derivatives are designed to allow the independent trading/hedging of credit risk. It is also possible to transfer and/or transform credit risk through securitisation.'' The securitisation process has become increasingly popular over the last decade, with structures ranging from the simple passing on of cash flows from underlying assets, to complex structures utilising credit derivatives. It is these latter structures that are important for this course, but we need to revisit the principles of securitisation in general to be able to understand the more complex products. Types of Credit Derivative Basically, three types of products can be distinguished, depending on the kind of risk transferred by the credit derivative: (i) total return swaps (ii) credit default swaps (iii) credit linked notes Trading Applications of Credit Default Swaps COMPLEX STRUCTURES Securitisation Concepts ''Securitisation is a group of techniques used for transforming illiquid sources of cash flow into tradable securities. Illiquid Sources of Cash Flow may include Home Loans ( Mortgages ), Credit Card Accounts , Car Loans , Consumer Loans , Corporate Bank Loans , Illiquid Bonds , Aircraft Leases , and many more asset and receivable types.'' Securitisation in Principle The aim of securitisation in general is to take an illiquid asset and transform it into cash. For instance, a leasing company may have provided £10m nominal value of leases, and it will receive a cash flow over the next five years from these. However, it cannot demand early repayment on the leases and so cannot get its money back early if required. If, however, it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the company originating the debts (the leasing company in our example) is a bank or other organisation that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts. In vanilla structures, the credit derivative is used to change the credit quality of the underlying portfolio of leases so that it will be acceptable to the final investors. The diagram below describes a typical transaction with this separate company (usually referred to as a Special Purpose Vehicle or in the USA as a Special Purpose Entity [SPE ).
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