IS CREDIT DERIVATIVE RISKY IN FINANCIAL INSTITUTIONS IN THE UNITED STATES

Is Credit Derivative risky in financial institutions in the United States

Is Credit Derivative risky in financial institutions in the United States

Introduction

A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfill certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.

The relevant credit events specified in a transaction will usually be selected from amongst the following:

The bankruptcy of the reference entity;

Its failure to pay in relation to a covered obligation;

It defaulting on an obligation or that obligation being accelerated;

It agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.

If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.

This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).

Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss.

Since the reference entity is not a party to agreement between the protection buyer and seller, the seller of protection has no inherent recourse to the reference entity in the event of default and no right to sue the reference entity for recovery. However, if the transaction were to be physically settled the seller of protection could derive a right to take action against the reference entity on the basis of the loan or securities acquired during the settlement process.

The Problem

The delinquency rate for credit derivatives in financial institutions

Statement Of Purpose

The purpose of this study is to address the question of whether financial innovation of credit derivatives and the consequent increase in derivatives trading or lower rates of financial institutions by default.

Conceptual Framework

This paper presents a conceptual framework for valuing ...