Credit Derivatives

Credit Derivatives

Credit derivatives are instruments that allow lenders to pass on to others the risk that borrowers will default in return for a fee. In other words, credit derivatives are securitized in that the risk is transferred to an entity other than the lender. Examples of credit derivatives include credit default swaps, credit sensitive notes, and collateralized debt obligations. The value of these instruments is derived from the credit performance of the underlying party. Credit derivatives can be highly valuable for a company looking to spread and minimize risk.

These derivatives arose to hedge and diversify credit risk and as a means for taking on credit exposure. In 1989, Enron created its Credit Sensitive Note (CSN) as a way to make money in a difficult time. According to the case, these notes were designed to lower the price risk for bonds by paying a different coupon as the firm's credit level changed. The coupon payments are linked to the S&P and Moody's credit rating of Enron itself. These unique types of debt paid interest rates that varied based on Enron's credit rating. When the rating was downgraded the coupon payments increased at a greater rate than when Enron's rating was upgraded. In other words, the coupon payments decreased at a slower rate when ratings improved than the larger rate when ratings worsened.

The outcome of this is a bond price influenced by probabilities of a change in credit ratings as well as credit risk, recovery rates, company performance, and the outlook for rates. What is unique about Enron's case sensitive note is that the bond price would not decline in a ratings downgrade scenario and would instead compensate for the default risk. This is a special circumstance seeing that most bonds default risk is correlated with their credit rating. Since Enron's case sensitive notes derive their value from Enron's performance, this makes the notes credit derivatives.

The Management of Credit Risk and Relation to Derivatives Operations

Credit risk originates from the inability of an organization to fulfill the financial commitment that was previously made. Through managing a firm's "own" credit risk, a company has the opportunity to significantly impact the risk they take on.

Enron has grown substantially through much capital spending and acquisitions over the decades. Since the company has grown to be one of the world's foremost energy providers there has been much change to stabilize and expand business segments. One segment in focus is Enron Capital and Trade Resources.

This trading division is the largest purchaser and marketer of natural gas in North America. The company manages the world's largest portfolio of natural gas fixed-price and risk management contracts and deals with a wide volume of transactions