credit

Uofcredit

derivatives

761

ManagerialFinance

Vol.32No.9,2006

pp.761-773

#EmeraldGroupPublishingLimited

0307-4358

DOI10.1108/81952

Creditriskmanagement

Theuofcreditderivativesby

non-financialcorporations

n

BradfordUniversitySchoolofManagement,Bradford,UK,and

BrianWright

SchoolofBusinessandEconomics,UniversityofExeter,

Exeter,UK

Abstract

Purpo–Thispaperaimstoexplorethepossibleuofcreditderivativesbycorporatetreasurers.

Corporationshave,inrecentyears,growncomfortablewiththeideaofusingtraditionalderivative

productstohedgetheirexposureto,forexample,risk,

ontheotherhand,avenuesforthemanagementof

creditriskdoexist,forexample,bytheuoftraditionalinsuranceproductsandlettersofcredit,

suchmeansarenotalwaysconvenient.

Design/methodology/approach–Inthispaper,boththeacademicandpractitionerliteratureon

,bymeansofsomesimplenumerical

examples,thepossibleustowhichcorporatetreasurersmightputcreditdefaultswapsandtotal

returnswapsareillustrated.

Findings–Thecreditderivativesmarketis,atprent,dominatedbylargebanksandinsurance

reditderivativesmarketbecomes

moreliquidandtransparent,itisasked:‘‘Shouldcorporatetreasurersconsiderusingcredit

derivativestomanagetheircreditriskexposure?’’Anumberofsimpleandpracticalwaysinwhich

corporationscanucreditderivativestomanageriskareexploredandthepracticalstrengthsand

weaknessoffollowingsuchapproachesareemphasid.

Originality/value–oneofthefirst

academicpaperstoconsidercreditderivativesfromafinancialmanagementperspective.

KeywordsRiskmanagement,Credit,Organizations,Derivativemarkets

PapertypeViewpointpaper

uction

Corporatetreasurershaveinrecentyearsgrownaccustomedtomanagingvarious

dimensionsoftheirfirms’ofderivativestohedgeinterestrateand

,formulti-national

firms,themanagingofsuchexposureisastandardpartoftheirtreasuryfunction[1].

Oneaspectoffinancialriskthathasprovendifficulttohedge,however,hasbeenthatof

mple,anon-

financialcorporationholdingalargeportfolioofthebondsofitscustomersand/or

suppliersisclearlyexpodtocreditrisk,asisafirmwhenitsuppliestoacustomeron

example,afirmthathasissuedexchangeablebondsthatareconvertibleintoathird

party’ssharesinwhichtheissuingfirmisasubstantialexistingshareholder,orthe

poolingoffinancialresourcesandrisksthatarisinjointventures,alliancesandfirm-

ialandindustrialcorporationshaveeveryincentiveto

losivegrowthofthecredit

derivativesmarkethasdistributedcreditriskthroughthefinancialsystem,packaged

ndingcreditriskmarketraisinterestingpossibilitiesfor

corporatetreasurerswishingtominimiexposuretocreditrisk.

Thecurrentissueandfulltextarchiveofthisjournalisavailableat

/

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Thispaperexaminestherapidlydevelopingmarketforcreditderivativesand

attemptstoanswer,throughariesofsimpleexamples,thequestionofwhether

corporatetreasurersshouldaddcreditderivativestotheirexistingarmouryofrisk

managementtechniques.

creditderivativesofall

types,about$5,000billionindebtwillhavebeenprotectedagainstdefaultduring2004.

Whilsttherangeofavailableinstrumentsandtheirapplicationcontinuestoincrea,

themarketstilllacks,atthetimeofwriting,thetransparencyandliquidityofmore

traditional,r,anumberofinstitutionalattempts

tostandardithemarket,forexample,bytheInternationalSwapsandDerivatives

Association(ISDA)andtheemergenceofactivecreditderivativeindicessuchasiBoxx,

conceivedbyaconsortiumofbanks,andTrac-X,launchedbyMorganStanleyand

JPMorgan(nowmanagedbyDowJones),arebeginningtofashionthecredit

mptismadehereto

consideralloftheavailableinstrumentsandapplicationsofcreditderivativesforthe

,weillustratethepotentialufulnessoftheinstrumentsby

focusinginontwoparticularkindsofinstrument:thecreditdefaultswapandthe

totalreturnswap.

n2introducesthecredit

derivativesmarketsandconsidersbrieflythemaincontractsavailableintheover-the-

n3looksattheimpactofthecreditderivativesmarketonnon-

ion4,weconsidertheuofcreditderivativesby

followed

up,inSection5,withaconsiderationofwhethermanagersshouldtradeincredit

y,forexample,wishto

purchacreditprotectiontohedgeagainstreceiptsfromfuturebondissuesorll

n6prentssummaryand

conclusions.

forcreditderivatives

Themarketforcreditderivativeshasbeen,andstillis,dominatedbybanksand

insurancecompanies,whotradecreditriskamongthemlveswithincentivesto

distributeanddiversifyrisk,gainadditionalyieldandtomanagetheircapital

velylargeinvestmentbanks,suchas

[2],snoexchange-

organidmarketforcreditderivatives;transactionsareconducted‘‘over-the-counter’’,

andthereisconquentlylessliquidity,standardisation,andtransparencythanis

,itisperhapsthisvery

fact,coupledwiththecomplexityofpricingcreditderivatives,whichhasdiscouraged

his,thepublic

suspicionofderivativesingeneral,generatedbytheconspicuousfailuresof

corporationssuchasEnronandBaringsBank,anditisnotentirelysurprisingtoe

heless,asweshall

show,creditderivativesprentauniqueopportunityforcorporatetreasurerstoadda

rentstateofaffairswithregard

tocorporateacceptanceofcreditderivativescanbelikenedtothatofthemanagement

entialforthegrowingfuture

mple,a1995US

surveyofnon-financialcorporationsrevealedthat52percentofrespondentfirmswere

Uofcredit

derivatives

763

e,18percentexpresda‘‘high’’

,n

surveyconductedbyAccenture[3]foundthat36percentofcompaniesbuycredit

insurance,32percentulettersofcreditand14percentucreditderivativesto

non-financialcompanieshaveadoptedaninterestedbut

cautiousapproachtocreditderivativeu,theoverallleveloftradinginthecredit

derivativesmarkethasroughlydoubledineachofthepastfewyears,withthetotal

marketsizegrowingsteadilyfrom$180billionin1997,through$586billionin1999,to

over$1.1trillionin2001(BritishBankers’Association(2002)).Thisactivitymostly

comprisbanksandotherfinancialinstitutionsforwhomcreditriskisnowan

importantfacetofriskmanagement,butitalsocomprisagrowingnumberof

non-financialfirmsasthemarketstartstoprovidethecomfortlevelsthattheirfinance

directorsrequire.

2.1Principalcreditderivativeproducts

Therangeofcreditproductsavailableislimitedlargelybytheperceivedneedforthem

andthecreativeimaginationsofthefinancialengineersputtingtheproductstogether.

Sincetheyaretradedover-the-counter,creditderivativescanbetailoredtosuitthe

r,underthetutelageoftheinstitutional

marketforsuchinstruments,thefollowingfourmaintypesofcontracthaveemerged

inthedrifttowardsstandardisation[4](,1998a):

(1)Creditdefaultswaps(CDSs)

(2)Totalreturnswaps(TRSs)[5]

(3)Creditspreadoptions

(4)Credit-linkednotes

Forreasonsofspace,thispaperwillonlyconsidercreditdefaultswapsandtotalreturn

swaps[6].

2001,for

example,single-nameCDSs[7]reprented45percentofthetotalmarketforcredit

derivatives(BritishBankers’Association,2002).Conceptually,theyarethemost

leterms,aCDSeffectivelyallows

theownerofanunderlyingcreditcuritytopasstheriskofdefaulttoabuyerofthe

mple,FirmAowns£1mnominalofthebondsofFirmB,whichare

redeemablein5years’nedaboutitxposuretoFirmB’sriskofdefault,

FirmAmaypurchaafive-yearCDSfromabankonthenominalamountof£1m.

Thismaybeacquiredbyanupfrontcashpaymenttothebankorbyaspecifiedannual

apre-specified‘‘creditevent’’occur,thebankwillmakeapaymentto

FirmA,ailsofthecreditevent,andofthe

precipayment,areamatterfornegotiationbetweenFirmAandthebank[8].A

typicalarrangementstipulatesthatthe‘‘creditevent’’isadefaultoncouponor

principalrepayments[9].Thepaymentondefault,receivedbyFirmAfromthebank,

mightbe,forexample,the£1mnominalvalueofthebond,lessthemarketvalueofthe

defaultedbond,aspecifiednumberofdaysafterdefault.

Atotalreturnswap(TRS)isanagreementbetweentwopartiestoswapcashflows

andotherreturns,charoftheTRSacquiresfromthe

,purcharacquiresan

amountequivalenttoanycouponorotherpaymentsduefromtheast,alongwithany

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carn,

thebuyerpaysafloatinginterestratetothelleroverthedurationofthecontract.

eroftheTRSownsa

positionthatissimilartoapositionintheunderlyingitlf,inthatbuyerpartakesof

antly,however,thebuyerdoesnothavetomakeany

upfrontinvestmentforthis.

Asalreadynoted,veralothertypesofcreditderivativeexistandareregularly

tradedintheOTCmarket,

remainderofthispaper,weillustratetheuofcreditderivativeswithsomesimple

examplesoftheuofCDSs;thereafter,wefocusourattentionontheTRSasapotential

ghnotthemostcommonlytradedinstrumentat

prent,theTRSprovides,undercertaincircumstances,aninterestingmixofcreditand

usapotentiallyufultoolforthecorporatetreasurer

lookingtomanagenotonlyinterestrateexposure,butalsocreditexposure.

-investorcreditderivativesmarketandnon-financial

corporations

Wenextconsidertheargumentsinfavourof,andagainst,theexistenceofaninter-

investormarketincreditderivativesfromthenon-financialcorporationperspective.

Approximately95percentormoreofthecreditderivativesmarketistraded

betweenfinancialinvestors[10].Doesthismarkethelpcorporationstoissuedebt,or

doesitadverlyaffectthecorporateloanmarket?Fromacorporateperspective,there

arefivemainadvantagestotheexistenceofthismarket:

(1)Sinceinsurancecompaniesaremajornetllersofcreditprotection,creditrisk

creas

thedemandforcorporatecreditandsoimprovesliquiditythatshouldleadto

moreefficientpricing,lowerfuturecreditspreadsandimprovedmanagement

ofcreditrisk.

(2)Theprenceofacreditderivativesmarketshouldenableanygivencompany

tohaveclorlinkswithasmallernumberofbanks,asthebankscanuthe

creditderivativesmarkettopassonthecreditriskthatwastraditionallytheir

prerve.

(3)

investordiversificationimproves,sothecostofallriskycapital,including

corporatedebt,shouldfall.

(4)Recentverylargecorporatedefaults,suchasWorldComandEnron,havehad

entsofthecreditderivatives

marketarguethattheimpactonthefinancialctorwouldhavebeenmuch

greaterhaditnotbeenfortheprenceofcreditderivatives.

(5)Iffirmshavesparecashorpension-fundmoney,theexistenceofacredit

d

Blackwood,ICIGroupTreasurer,hasrecentlybeenquotedassaying[11],‘‘They

...islikelytobethemostactive

[areaofusage]forcorporates’’.Suchacomplexandopaquemarketmaywell,

though,onlybeanappropriatearenaforthemostsophisticatedpensionfund

managementschemes.

Uofcredit

derivatives

765

Thereare,though,veraloffttingreasonsforcompaniestobeconcernedaboutthe

prenceofacreditderivativesmarket:

(1)Severalcommentatorshaveconcludedthatthismarketisthegreatestpotential

everalleadingauthorities,

includingAlanGreenspanandFitchRatings[12],continuetobelievethatthe

creditderivativesmarketleadstoanoverallreductioninrisk,others,notably

WarrenBuffett,ainable

levelsofriskare,theyargue,createdbythelackoftransparencyoftheOTC

uld

2003

‘‘BananaSkins’’surveyconductedbytheCentreforFinancialInnovation/

PriceWaterhouCoopersplacedcreditderivativesasthemostimportant

sourceofriskcurrentlyfacedbybanks.

(2)Ithasbeenarguedthatbanksarewillingtoloss-leadoncorporateloansin

nceofacredit

derivativesmarket,though,makesthecostofcreditriskmoretransparentand

thereforewillenablebankstodemandhighercorporatebondrates[13].This,

however,mple,Rule(2001)

illustratesthat,inSeptember2000,thecreditspreadsonsingle-namecredit

derivativeswerelowerthanthecorrespondingspreadsonevenAA-rated

telecoms’tion,evenifloss-leadingoncertaincorporateloansis

explicitratherthanimplicit,thismaynotnecessarilycaubankstochange

existingbusinesspractice.

(3)Thereividencethatthecreditderivativesmarketisdistortingtheprimary

marketincorporatebondissues[14].Speculatorsllshorttheunderlyingbond

priortoissueandhedgethecreditrisk,buyingbackthebondonthefirstdayof

lityofinvestorstotakeshortaswellaslongpositionsinthecredit

riskaddsvolatilitytotheimmediatepost-issuemarket,andpossiblythepre-

r,itcouldbearguedthatasthisstrategyincreas

demandforthebond,thisisgoodfortheunderlyingfirm.

(4)Sincebankshavenoobligationtodisclotheirdealingsinthecredit

derivativesmarketwiththeirclient,itcouldbearguedthatthemarketmay

n,DirectorofTreasuryat

CadburySchweppes,hasbeenquotedassaying[15],‘‘Thebankswhichare

ynotcare

aboutourperformance’’.

Therefore,whilethecreditderivativesmarketlooksttogrowfortheforeeable

future,thecorporatectorhassomejustificationforitsapparentambivalenceabout

therhand,manyofthedisadvantagesofthecorporateuof

creditderivativesareofthenatureofanexternality:theyaredisadvantagestothe

corporatectoroftheuofcreditderivatives,

consideredsomeoftheargumentsthatmaybeadvancedforandagainstthecredit

derivativesmarket,wenow,inthelightoftheabovepotentialadvantagesfor

corporations,illustratewaysinwhichcreditderivativesmaybeudtoreduce

corporatecreditriskexposure.

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ngexternalcreditexposure

Thisctionexamines,bymeansofthreeillustrativeexamples,theuofcredit

sttwo

examplesillustratetheuofCDSstomanagecustomercreditandsovereign

governmentexposure;theremainingexampleexaminestheuofTRSs.

e1

belowgivesatypicalscenario.

Example1

xpodtocreditriskononeofitsmajorcustomers,FirmY,to

whichitllsasignificantportionofitsproductsonconventionaltradecreditterms.

Monthlysalestothecustomeraverage£1m,andthreemonths’tradecreditisallowed.

Thus,onaverage,FirmXixpodto£3mofFirmY’screditrisk,onamore-or-less

permanentbasis.

uysaCDSwithanotionalamountof

£3monabondissuedbyFirmY.

rnforanannualpayment,thecounterpartywill

paythedifferencebetweenthenotionalamountofthebondofFirmY(£3m)andthe

marketvalueofthisbondinthecathatFirmYdefaultsonthebond’sobligations.

Strengths/rategyprotectsFirmXfromFirmYgoingbankrupt.

Inthisca,thebondwillbeworthverylittleandthereforetherewillbealargepayoff

tingthis,FirmXwillnotberepaidonthe£3moftrade

r,ifFirmYdefaultsonitstradedebtbutdoesnotdefaultonitsbonds,

thenthisstrategywillnotprotectFirmX.

FirmXcouldalsouCDSstoprotectitsbondholdingsinacustomerorsupplier

ppothat,insteadofextendingtradecredittoFirmY,FirmXholds£3m

ofthebondsofFirmYandprotectsagainstthecreditriskofthobondsby

purchasingaCDSonanotionalamountof£sinthehightechnology

erwhathappenstoFirmX’spositionifthereisageneraldownturninthe

ca,althoughthecreditspread

onthebondsofFirmYmaywiden,loweringthemarketpriceofFirmY’sbonds,no

,althoughprotectedagainstdefaultrisk,FirmXisstill

expodtoaconsiderableamountofspread-badrisk[16].Analternativehedging

strategyexistsforprotectingFirmXagainstexposuretoitscustomer’

Example2shows,analternativetousingCDSs,andonethatwilleradicateallofthe

creditriskborne,istollaTRS.

Example2

litatetraderelations,FirmXbuys£5mofFirmY’sten-year,zero

asfundedthepurchaofthebondsbyborrowingatthe

short-terminterestrate.

ntersintoa£5mnotionalTRSonthe

bondsofFirmYinexchangeforthebeginning-of-yearLIBOR(excludingspreadsand

transactionscosts),withannualpayment[17].

ellsthetotalcapitalchangeonFirmY’sbondsin

example,bond

valuebe£3matthestartoftheyearand£rmX

mustpaythetotalreturnonthebonds(£3.15mÀ£3m=£0.15m)andreceives

Uofcredit

derivatives

767

LIBOR=4percent£5m=£ouldthenreceiveanet£0.05mfortheyear,

minusanytransactionscosts.

Strengths/eiptof

LIBORonitsTRSpositionofftstheinterestthatithastopaytofundthepurchaof

lineinbondvalueisperfectlyofftbythetotalreturncomponent

re,though,restratesri,thenthe

priceofFirmY’sFirmXisconcernedfromitsbondholding

position,r,thecashoutflowthatFirmX

mustmakeontheTRSfalls,ore,fromacash

flowperspective,FirmXgains(los)ifinterestratesri(fall).Thisiquivalenttoa

futures’‘‘markingtomarket’’effect.

Thisctionconcludesbyconsideringhowcreditderivativescanbeudtomanage

e3concentratesonCDSs,butTRSscouldalsobeudinthis

ca.

Example3

boveisalsoconsideringenteringintoaninfrastructureprojectina

developingcountry,butisconcernedthatthegovernmentmaynotbeable,orwilling,

tofulfilitspaymentobligationsinthefuture[18].

uysaCDSonthesovereigndebtofthe

‘‘creditevent’’stipulatedbythecontractwouldbea

downgrading(ratherthanoutrightdefault)oftheunderlyingbond

Strengths/ulatingthatthecrediteventisadowngrading,nota

default,ofthesovereigndebt,FirmXisprotectingitlfagainstthepossibilitythatthe

developingcountrydefaultsonitstrade,butnotfinancialmarket,

r,thereis

stillnotperfectcorrelationbetweenthebusinessandbondrisks,meaningthatthisis

rthisispreferabletopoliticalriskinsurancewilldepend

ontherelativetransactionscosts[19].

nginternalcreditexposure

Whilstthemostobviouscorporateuofcreditderivativesisformanagingthecredit

risksofcustomersand/orsuppliers,anotherinterestingpossibleapplicationrelatesto

retwomain

,acompanymay

irstexample

giveninExample4,asimplecaisprentedtodemonstratehowacompanycould

uturecost

ofcorporateborrowingweretoincrea,caudeitherbyachangeininterestratesor

byanincreainthecreditspread,thenthiswouldleadtoacontemporaneousfallin

erivative’spositionisshortinthebonds,

ca,thecompanyis‘‘buying’’itsowncredit

econdca,managersmaywishto‘‘ll’’creditprotectionontheir

ownf

companycanthenreclaimonthederivativesomeofwhattheyarelosingonthehigh

ondexamplegiveninExample5showshowTRSscanbeud

etailedanalysisofExamples4and5isgivenintheappendix.

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Example4

estoextend

thisissuenextyearandwishestocuretheamountthatitwillreceive.

ntersintoaTRSonitsownbondsin

exchangeforthebeginning-of-yearLIBOR(excludingspreadsandtransactionscosts),

withannualpayment.

ivingLIBORontheTRS,FirmXcanperfectly

identify,attheoutt,thecashinflowfromthisderivative’houtflow–

thetotalreturnonitsownbondoverthenextyear–r,

changesintheexistingbondvalueperfectlyhedgeschangesinthereceiptsfromthenew

bondissue,andthereforethisshouldbearisk-freeinvestmentstrategy.

Strengths/rategyreliesontheremainingmaturityoftheexisting

becauthensitivityof

corporatebondpricesdependsonbothinterestratemovementsandchangesincredit

sitivityoffixedincomecuritiestochangesininterestratesisafunction

podinvestmentstrategyisrisk-

ore,whilethis

isarisk-freestrategyforanextensionofanexistingbondissue,itmaynotbeaperfect

hedgeforanewissueofbonds.

Example5

asissuedbondsandbelievesthatthepriceithasreceivedonthis

is

sametime,FirmZwishestoprotectitlfagainstthebusinessriskofaclient,FirmX.

irst,it

econd,

itreceivesLIBORinexchangeforpayingthetotalreturnonFirmX’sbond.

ORcomponentofthetwoTRScontractxactly

offtachotherandthereforeFirmZiffectivelyswappingthetotalreturnsonX’s

bondforthetotalreturnonitsownbonds.

Strengths/thepreviouxample,itisimportanttomatchthe

durationandconvexityofthetwobondstoensurethatthecontracthasnounderlying

plainswhyitisnecessarytohavetwo,

offtting,irmZthinksthatitsbondsweresoldtoo

cheaply,bybuyingthetotalreturnsonthebondsitixpectingtomakean

,managementmaynotbeabletoestimatethecompany’s

,thereissomeevidenceofover-

optimismbyestablishedmanagement(Heatonm,2002),andthusadangerthatthere

illalsobeexpodifthe

priceofFirmX’r,since

FirmXisaclientofFirmZ,themanagersofFirmZwouldhopethatthisimprovement

inthefortuneofFirmXwouldbeaccompaniedbymoreunderlyingbusiness.

sion

Thispaperhasprovidedaconciintroductiontothecorporateuofcredit

theuptakeofcreditderivativesby

corporatetreasurershasbeenslowuptotheprenttime,wehaveattemptedto

illustrate,bymeansofsimpleexamples,thatthescopeforcorporateuofthe

derstandablethatcorporationshavetreatedtheuof

Uofcredit

derivatives

769

creditderivativeswithawaryeye,giventhefactthatthemarketisstillinarelatively

organisationssuchastheInternationalSwapsand

DerivativesAssociationhavemadestridesinattemptingtostandardiandclarify

contractterms,icular,there

issomeconcernthatthefurtherdevelopmentanduofthecreditderivativesmarket

willerodeclorelationshipsbetweenfirmsandtheirbankers,andthatthemarket,far

fromaddingdiversificationandloweringriskpremiums,willaddtotheriskofa

‘‘houofcards’’

marketmaturesanddevelops,therewillbeaneedforfurtherrearchintotheimpacts,

beneficialorotherwi,ofthecreditderivativesmarketonthecreditmarketingeneral,

panylevel,

however,creditderivativesprovideaversatile,andpossiblycheaper,alternativeto

ctiswitnesdbytheobrvationthat

manyinsurancecompaniesnowuthecreditderivativesmarkettotradeonsomeof

theirowncreditrisk.

Notes

,forexample,GuayandKothari(2003).

tishBankers’Associationestimatethat,in1999,forexample,banksaccounted

for63percentofthebuyside,

percentage,however,hasbeendecliningovertime,withinsurancecompaniesin

imatethatin1997/98,insurance

1999,thispercentagehadrinto

23percent.

3.‘‘Managingriskwithcreditdefaultswaps’’,CorporateFinance,August2001.

rtantefforthasbeenmadeinrecentyearstobringadegreeofstandardisation

toover-the-counterderivativeproductdocumentation,includingcreditderivatives.A

majorpartofthisstandardisationefforthasbeenledbytheInternationalSwapsand

DerivativesAssociation(ISDA).Readersinterestedinviewingsomeofthestandardid

documentationshouldconsulttheISDAwebsite:.

ghtheacronym‘‘TRS’’willbeudthroughoutthepapertorefertototalreturn

swaps,alreturnswapis

sometimesalsoreferredtoasatotalrateofreturnswap.

swhoareinterestedintheapplicationsofotherkindsofcreditderivativemay

consultAnsonetal.(2004)forgeneralcoverageofcreditderivatives,anddetailed

descriptionsofspecificinstruments,includingCDSs,TRSs,credit-linkednotes,credit

spreadoptions,linterestingarticles

covercreditderivativesinanon-technical,accessiblestyle:(1998a,b);

Ivey(2002);Seyfried(2001)(onCDSs);Nordoneetal.(2001)andSenior(1999).

-nameCDSsarebadonthedebtinstrumentsofasinglecompanyorotherentity.

‘‘Basket’’CDSsarealsotraded,witha‘‘basket’’ofcompanies’debtinstrumentsasthe

underlyingcurities(eAnsonetal.(2004,Chapter3)foradetaileddescriptionof

basketCDSs).

1999,alistofeightpossiblecrediteventswascompiledbyISDA,intheirCredit

ventsmaybelected,individuallyorincombination,by

partiestoaCDS,tedcrediteventsinclude,for

example:bankruptcy;merger;credit-ratingdowngrade;failuretopay(amountsdue);

andrestructuring.

ailedandexactdefinitionofacrediteventisacrucialaspectofaCDS,and

shouldbeconsideredcarefully.

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10.‘‘Treasuriesfightshyofcreditderivatives’’,CorporateFinance,October2002.

,‘‘Corporatecreditderivatives:aretheyirrelevant?’’CorporateFinance,October

2003.

12.‘‘Globalcreditderivatives:aqualifiedsuccess’’,FitchRatings,September2003.

,forexample,n,‘‘Creditderivatives’knock-oneffects’’,TheBanker,9June

2003.

,forexample,thectionon‘‘Risksarisingfromcreditderivatives’’,FinancialRisk

Outlook,2004,FinancialServicesAuthority.

15.‘‘Passingthecreditriskparcel’’,,September1998.

‘‘creditevent’’isdefinedasadowngradeinthebond’srating,thenacertainamount

ofthisspreadriskmaybehedged;therestillremains,however,aresidualamountof

creditspreadriskassociatedwiththebondsofFirmY.

ketpriceofthebondiswellbelowthefacevalue,sincethebondiszero-coupon

ore,evenifthebondreturnissomewhathigher

thanLIBOR,FirmXwillreceiveanetcashinflowfromtheTRSifthespreadis

his,itislikelythatthespreadontheTRSwillbereasonablyhighin

thisca.

panycanprotectagainstthispoliticalriskintheabnceofacredit

derivativesmarket–forexample,itcouldpurchapoliticalriskinsuranceeither

privatelyorfromtheExportCreditsGuaranteeDepartment.

entialargumentinfavourofcorporateinterestinthecreditderivativesmarket

istheobrvationthatmanyinsurancecompaniesarenowutilisingcreditderivatives

panycandothisdirectly,thenperhaps

theycanavoidsometransactionscosts,andthusinsuretheirownrisksmorecheaply.

recimethodofconvertingfromthecontinuous-timeOrnstein–Uhlenbeck

modelstoadiscrete-timeinterestratemodelisgivenbyNowman(1997).Estimatesof