Credit Derivatives: What are they? Why is their use growing so significantly? What are they used for?

Credit derivatives include widely used risk management tools such as total return swaps and credit swaps, as well as structured investment products such as credit linked notes. The features and terminology associated with these instruments are explained. These and other credit derivatives enable banks and financial institutions to make credit and investment decisions that provide for effective utilization of the firm's capital and enhance return on scarce capital. Several examples of investment, hedging and trading strategies will be presented.

In this course, these instruments will be shown to have pricing models that depend on the option-like features of the underlying credit. The various credit events that trigger a payment under a credit derivative are examined, as well as the alternative mechanisms for making those payments. Exercises are employed to demonstrate the settlement process under various scenarios.

The relationship of credit derivative spreads to the risky asset yield curve is explored. The concept of loss given default (LGD) is introduced, and the forward credit curve is derived as a methodology for the pricing of credit derivative instruments.

Accounting standards for credit derivative products are discussed, with attention paid to IASB and FASB standards. Treatment of credit derivatives for determination of credit risk capital under the Basel Accords is also addressed.

Objectives

Upon completion of the course, the participant will be able to:

• Explain the concept that debt is a put option on the firm's assets
• Describe the features and cash flows of total return swaps, credit swaps and credit spread options
• Understand the option-like characteristics of a credit swap
• Explain the various concepts of the credit event
• Calculate the settlement payment under various total return and credit swap scenarios
• Estimate the credit swap spread on bond market rates and spreads
• Identify the components of a credit linked note
• Explain the accounting treatment of credit derivatives under IAS 39 and FAS 133

This course is for people who are new to the areas of credit risk, credit derivative products, and derivatives hedging.