Financial Instrument

1. What is a credit derivative?

Credit derivative is a financial instrument or derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded.

It is derivative instruments that provide protection against credit risk, that is, default risk, credit spread risk, and downgrade risk. Default risk is that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. Credit spread risk is that an issuer’s debt obligation will perform poorly relative to other bonds due to an increase in the credit spread. And downgrade risk is that an unticipated downgrading of an issue or issuer increases the credit spread and results in a decline in the price of the issue or the issuer’s bonds.

Credit derivatives enable banks and other financial institutions to actively manage their credit risks. They can be used to transfer risk from one company to another and to diversify credit risk by swapping one type of exposure for another.

2. Why is the management of the firm’s “own” credit risk important to its derivatives operations?

First, in the market point of view, the price of the credit derivatives is directly affected by the change of the credit risk. Moreover, credit derivative market is much larger than underlying assets market because the transaction of the credit derivatives occur repeatedly and derive to other derivatives. So, the price of the credit derivative is more volatile when there is small the change in the price of the underlying assets. Therefore the credit event of the firm shake the market and result in the crisis of financial market.

Second, in the individual firm’s view, the credit risk of the firm is exactly reflected to the credit derivatives. In the past, the change of credit of the firm is generally noticed by the financial institution that works closely with a particular company by providing advice, making loans, and handling new issues of securities. But, the credit risk get to be open to the public right away by the credit derivatives. It means that the company get into financial cisis at once when it fails to deal with its own credit risk. The debt cost will rise, the new loan may be suspended, and the renewal of the loan may be denied by the banks when the credit derivatives price go up. Therefore, the firm should control its own credit risk carefully.

3. What are the different approaches to managing one’s own credit risk?

a) Credit Valuation

By the due diligence and analysis of the credit, the financial institutions should recognize the debtor’s attribute and its chance to be default. And then, they should judge to make a loan or not. But, this method