Credit derivative

Credit derivatives are a subspecies of the derivatives and tradable financial instruments, loan, loans, bonds or similar assets as underlying ( "underlying ") to the content and secure the measure inherent risk of default protection buyer and increase the protection seller. There are also purely speculative variant of the uncovered ( "naked " ) Credit derivatives without underlying security.

Formation

Credit derivatives are a relatively new financial instrument. It was developed by the investment bank Bankers Trust in 1991. The international market for credit derivatives had reached an interesting field for all market participants volume threshold in 1996 for the first time. A survey of the Deutsche Bundesbank among the 10 most active German banks in the credit derivatives market, showed in 2004 that these institutions occurred at about € 220 billion as protection seller and € 210 billion as protection buyer in " single-name CDS". The German Bundesbank had found this from a regulatory perspective that the CDS markets " by the faster processing of new market information to the bond markets have a price leadership and a clear lead character in front of a creditworthiness downgrades by rating agencies ." Only at the beginning of the Asian crisis in August 1997, the worldwide interest had risen to a risk transfer in the form of credit derivative, and after the Russian crisis in August 1998, the market share was finally grown rapidly.

Legal Issues

When credit derivatives, there is the protection buyer (buyer; "protection buyer" ), the protection seller ( seller; "protection seller" ) and the hedged underlying transaction (underlying asset, "underlying " ), ie the credit risk inherent in a loan, credit or a loan to the reference entity. The creditor of such credit risk may have an interest to hedge its exposure to credit risk by buying protection through a credit derivative. Yet his credit risk is retained him; it is hedged by the credit derivative. The original loan relationship of the secured party with the reference entity is neither changed nor re-established. Credit risk and credit derivatives exist, therefore the collateral taker in parallel. This is the guarantor different. It appears as a contracting party to only the credit derivative, without having to have been a reference to the Reference Entity. It was only in his capacity as protection seller buys a credit and risk having to pay with a credit event to the protection buyer.

According to the legal definition of § 2 para 2 No. 4 WpHG credit derivatives " as all purchase, exchange or otherwise configured hard or options transactions that are delayed in time to meet and serve the transfer of credit risk ." In § 1, Section 11, sentence 3 No. 4 KWG coincident with the German Securities Trading Act legal definition is included.

Credit default swaps, total return swaps and credit linked notes are in accordance with § 165 of the Solvency Regulation credit derivatives regulatory approval as collateral with the secured party if one of the defined in § 165 No. 1 Solvency credit event has occurred and the determination of the event not only in the responsibility of the protection provider falls. In addition to the ( non-exhaustive ) list of the Solvency it comes particularly important that the finding that such an event is deemed to have occurred, may not be the responsibility of the protection provider alone. If the master contracts ISDA ( " ISDA Master Agreements " ) are used, this is ensured, since the finding of a credit event is removed from the Parties and exclusively to the ISDA Determinations Committee is responsible. The Solvency counts concretely the following credit events:

• After a waiting period the debtor of the legal position has not paid the arrears,
• Over the assets of the debtor of the legal position of insolvency proceedings have been opened,
• The debtor of the legal position is insolvent or has its debt service generally set
• The debtor of the legal position in writing its inability agreed to provide services its debt in general,
• Or similar events have occurred.

If the requirements of § 165 of the Solvency Regulation, the protection buyer may be credit risk than secured with warranty credited with the result that a lower capital adequacy spec is required. Credit derivatives are therefore a useful tool in risk management, as a premium, an existing credit risk is borne by the protection seller.

Forms of credit risk

In the risk analysis, it classifies risks mostly in the two main groups

• Market risk (price risk in foreign exchange rates, interest rates, equities ) and
• Address risks.

In the address risks pure credit risk (default ) and the credit risk ( spread risk) can be distinguished. In the so-called default risk a failure to provide credit performance is always the triggering credit event, while an expansion of the risk premium is (spread to the risk-free rate ) and thus the present value decay of the building as a basis for the credit risks. In this respect, credit derivatives can be divided in failure -related and rating -related credit derivatives.

Classification

Generally, a distinction is made between event-related and market- price-related credit derivatives.

• In event-related credit derivatives are made ​​payments to the protection buyer upon the occurrence of a defined when the underlying reference entity credit event the protection seller. Since the payment obligation of the credit derivative is directly dependent on the occurrence of a credit event, are a clear definition and an independent verifiability of this event is crucial.

• When market price -related credit derivatives based payments between the parties on the performance of a particular financial instrument or its relative share price performance to the relevant total market. Deterioration in the creditworthiness of a reference entity has a negative effect on the price development of a financial instrument issued by him. When market price -related credit derivatives in the case of a positive price performance payments from the buyer to the seller of the credit derivative and done vice versa.

Species

Through the innovation of the credit system, particularly in the field of derivatives biodiversity is constantly increasing. Here should be mentioned the most important.

• Credit default swap and credit default option of their mode of action similar to a guarantee. Both credit default variants may be particularly distinguished according to whether the acquisition of an underlying asset ( "Physical settlement" ) or a cash settlement (" Cash settlement" ) was agreed. Is a "Physical settlement" agreed, the secured party must actually owned the underlying security to be to deliver him in the case of a credit event the protection seller can ( credit default swap). However, if a " cash settlement" agreed, ownership of the underlying asset is not necessary because it comes to a cash settlement ( credit default option). Besides the classic credit default swap, there is also the "naked " ( uncovered ) CDS (credit default swaps without underlying security ), which is used purely for speculative purposes and does not have the protection of a credit risk to the content. The "naked CDS " on sovereign risk is generally prohibited by the EU from November 2012 to stop speculation on the threat of national bankruptcy. Only those who possess bond and loan portfolios in respect of countries can acquire CDS and thus hedge its default risk. Next allowed therefore remains the "naked CDS" against non- reference entities.

• A credit linked note is a structured security that a credit default option as a derivative component - cash-settled - contains. Here is the seller of the bond, the beneficiary of the derivative contained therein.

• When total return swap, the yield of the underlying asset is exchanged for a different yield. The equity swap is a total return swap where the Underlying is a share. Thus there is an exchange of the proceeds of a share against an other income.

• The credit spread option is an option on the spread between two basic values ​​, of which at least one is a credit risk. Credit spread options are available in different variants. Your Underlying Underlying can be both a reward and a price difference, they may relate to interest and dividend stocks, and they may have a wide variety of payoffs and conditions.

• The credit spread forward is a forward contract on the spread between two basic values ​​, of which at least one is a credit risk. Credit Spread Forwards are also conceivable in various forms. Analogous to the credit spread option can be an underlying their underlying price or yield spread, which they can relate to interest or dividend stocks.

Standardization

Since 1998 is the International Swaps and Derivatives Association (ISDA ) standard documentation for credit default swaps are available which allows a selection from the given alternatives to the parties involved. The ISDA Master Agreement, the Parties facilitate the negotiations, as fundamental questions no longer need to be clarified.

Accounting

Credit derivatives are bilateral contracts compulsory, their mutual claims are fulfilled at the balance sheet date as incomplete. They therefore belong to the category of pending transactions. These are in accordance with § 19 Section 1 Sentence 2 No. 3 and 4 of the Banking Act for off-balance sheet business of credit institutions and are therefore " under the balance sheet " ( " bottom line " ) enter. For accounting purposes, derivatives must not be offset against each other, even if the contracting party ( " counter party" ) netting agreements exist. The proposed herein offsetting builds on the occurrence of certain events and does not meet the rule IAS 32.42, which allows netting when a present and enforceable right to netting is. Therefore, here is the general prohibition to offset to be observed in accordance with IAS 1:32. Credit derivatives are accounted for in general accordance with IAS 39 and IAS 37 as derivative financial instruments. In addition, under German law, the prohibition to offset applies pursuant to § 246 para 2 HGB, so that the " bottom line " designated reflects the gross volume ratios.