Credit Derivatives Market

By: EconomyWatch Content   Date: 29 January 2010

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The credit derivative market serves as a bridge between commercial banks and other financial institution, such as mutual funds operators or insurance companies. From being a $40 billion market in 1996 to an almost $740 billion industry in a little over a decade, the market has been accepted by all the major banks and financial institutions across the world.

 

With time, the variety of credit derivatives has increased as well and can be classified into different products on the basis of the risk they transfer.

How Does the Credit Derivatives Market Operate?

 

The credit market, innately, entails a high degree of risk. Even the most careful lending can go wrong unexpectedly. Therefore, all forms of credit require special focus at the time of dispensing them. Likewise, different risks and credit forms require different kinds of protection, which the credit derivatives market has evolved to possess.

 

Typically, the credit derivatives market can be divided into the following categories:

  • Credit default swaps

  • Total rate of return swaps

  • Equity Default Swaps

 

In credit default swaps, the protection buyer keeps paying a premium to the protection seller. The credit or debt is transferred to the protection seller once any of the events mentioned in the contract occurs.

 

In a total rate of return swap, the parties arrange the terms for transfer of cash in case of appreciation or depreciation of the underlying asset. The return reference points are mutually agreed upon. The exchange occurs from the protection buyer to the protection seller when the prices increase on the assets and vice-versa. This transfers both the credit risk as well as the price risk.

 

Equity default swaps are new entrants in the credit derivative market. The nomenclature of this contract is still a matter of debate for many. After all, how could an equity default?  EQS picks its name from credit default swaps, whose operational process it replicates. The protection sellers and buyers transfer funds at a trigger event that is the net percentage increase or decrease of the underlying asset. It works on the basis of accepting a deep decline in the market value as the indication of default or its initiation.

 

 


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