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Curing Credit Risk: Credit Derivatives

Several methods and instruments for handling credit risk have been developed over the years. Of course, the easiest way to avoid credit risk is to refuse making a loan. Although this may be a pretty infallible method of credit enhancement, it eliminates the possibility of making any kind of a profit. Other methods are less drastic. Some of them involve changing a company’s business practices—for instance, asking for payment before the service or product is delivered. This is more natural for some businesses than others; popular examples include magazine subscriptions, health club memberships, or travel. If the company cannot manage this change in cash flow, it can still improve its credit exposure. For instance, the company mentioned earlier with a 30-days net payment practice can simply tighten the payment terms to, for example, 15 days. It can apply this practice across the board for all customers, or just for troubled clients with a history of paying late or not at all. Companies can also sign up for insurance products or ask for guarantees or letters of credit from their counterparts.

More advanced methods involve financial instruments known as credit derivatives.1 Initially created by actors in the financial sector, such as banks and insurance companies, these tools are now also commonly used by regular commercial businesses. Credit derivatives include instruments such as total return swaps, credit spread options, and credit linked notes. They all serve the same primary purpose: to help companies and institutions reduce credit risk by separating out the credit risk part of an investment or asset and sell it onward. As an example, let’s return to the bank that was considering making a loan to a steel factory. The bank believes in the project, and wants to grant the loan. However, it already has a number of loans outstanding to other steel factories, and worries about its overall exposure to the steel industry. If the steel sector were to experience economic difficulties, the bank would have a number of borrowers that might be unable to pay their interests or repay their loans. Therefore, to be able to grant the loan to the new steel factory, the bank (let’s call it Bank A) turns to another bank (Bank B) and enters into an agreement using a credit derivative mechanism.

The agreement says that if the steel company stops its loan payments (or defaults on them, to use the industry jargon), Bank B will pay Bank A the amount in the place of the steel company. For this service, Bank A will pay a monthly fee to Bank B. Hopefully, the steel company will never default on its loan payments, but if it does, Bank A is now insured against the effects of that eventuality. On the one hand, Bank A’s credit exposure improves. On the other, Bank B earns a monthly fee and wagers that the steel factory will probably not default on its loan.

This basic agreement is an example of a credit derivative (in this case, a credit default swap). Credit derivatives are financial instruments or contracts that allow a participant to decrease (Bank A in the preceding steel example) or increase (Bank B) its exposure to a particular type of credit risk for a specified length of time.

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