Credit risk is the risk that a borrowing entity, e.g. a bond issuer, will default on a loan, either through inability to maintain the delivery of the interest or because of insolvency leading to inability to repay the principal itself. To meet the need of investors to hedge this risk, the market uses credit derivatives. These are financial instruments originally introduced to protect banks and other institutions against losses arising from credit events. The payoffs of such instruments are linked in some way to a change in credit quality of an issuer.
There are two major categories of credit derivatives. First, a credit default swap (CDS) is simply an exchange of a fee in exchange for a payment if a credit default event occurs. Credit default swaps differ from total rate of return swaps in that the investor does not take the price risk of the reference asset, but only the risk of default. For example, a bank that has loaned $10 million to a company might enter into a $10 million credit default swap with a third party for hedging purposes. If the company defaults on its debt, the bank will lose money on the loan, but make money on the swap. Conversely, if the company does not default, the bank will make a payment to the third party, reducing its profits on the loan.
Second, a collateralized debt obligation (CDO) is a pool of debt contracts built in a special purpose vehicle (SPV) whose capital structure is sliced and resold, based on differences in credit quality. In a cash CDO, the SPV purchases a portfolio of outstanding debt issued by a range of companies, and finances its purchase by issuing its own financial instruments, including primarily debt, but also equity. In a synthetic CDO, the SPV does not purchase actual bonds, but instead enters into several credit default swaps with a third party. This way a synthetic exposure to outstanding debt is created. The SPV finances its purchase by issuing financial instruments to investors. However, these instruments are backed by credit default swaps rather than actual bonds.
As the most recent financial market crisis clearly indicates, credit derivatives house a complex structure and many hidden and large risks, so that a thorough modelling and treatment of these instruments is required - one of the key expertises of Benoist & Company.