Types of Credit Derivatives and Their Pros and Cons

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Table of Contents

Introduction
Credit Derivatives: Pros and Cons
Conclusion
References

Introduction

A credit derivative is a decent way to reduce risks in business and gain profit. It is a financial contract that allows a company to minimize its exposure to the risk of default (Chen et al., 2022). All types of derivatives have their advantages and downsides that have to be considered before taking any action.

Credit Derivatives: Pros and Cons

The first type of credit derivative to discuss is the credit default swap. It allows an investor to offset or swap their risk with that of another investor (Chen et al., 2022). It can be used to minimize the risk of default; a lender can buy a credit default swap (or CDS) from another investor who agrees to compensate them in case of borrower defaults. CDS requires one party to be the institution that provides the debt (a borrower), the second to be a buyer, and the seller, who will guarantee the underlying debt; it can be a bank or insurance company. This type of credit derivative provides risk protection, enhances the portfolio, and does not require exposure to total debt. In general, the drawbacks of CDS are overlooked and ignored. Among them are trading over-the-counter, low regulation level, and exposure to the seller’s creditworthiness. Furthermore, it can lead to substantial seller losses.

The next type of exploring is a collateralized debt obligation or CDO. Chen et al. describe it as “a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors” (2022). All sorts of loans, like student, vehicle, business, aircraft, and card debt, back this type of derivative. Though CDO is risky and not for all investors, this viable tool can be used “for shifting risk and freeing up capital” (Chen et al., 2022). CDO’s disadvantages are that it is a complex financial product, “too much liquidity can create real estate asset bubbles, and too much capital chasing too few deals causes real estate prices to rise and cap rates to compress” (Rohde, 2022). In general, it has to be applied wisely and carefully.

Total return swaps are the third type of derivative to discover. Chen et al. state that it is a swap agreement “when one side makes payments based on a rate while the other one makes payments based on the return, which includes income and capital gains” (2022). This type allows the party to receive benefits and total returns from the asset without even owning it. Total return swaps are highly beneficial for hedge funds because they give profit to an asset with a minimal investment. However, swap documentation is required of it, and it expires every 5-7 years, which can be flawed for some people.

A credit spread option (also known as a credit spread) is the next type to explore. In general, it is an options deal that contains buying one option and selling another identical option at the other price (Chen et al., 2022). It enables one to make money when the share price stays stable and generates income. This type of credit derivative has to be applied when the seller assumes the cost of the underlying asset is going to be higher or before the expiration date. The main disadvantage is that the number that is spent on the long-term option will decrease the profit potential (Frederick, 2022). Thus, credit spread options are beneficial, even when the stocks do not move.

The last type of credit derivative to discuss is the recovery lock transaction. It generally allows the parties to direct the reestablishment after the default. It is used to protect a company in cases when the risk of default is high and the parties want to recover their assets afterward. Unfortunately, it has a poor degree of concurrency and information inconsistency between many transactions.

Conclusion

In conclusion, all types of derivatives have their advantages and downsides that have to be considered before taking any action. The point is to apply them wisely, according to the outcome a person or company wants to receive. They allow reducing any risks, making more profit, and letting the assets enlarge.

References

Chen, J. (2022). Credit derivative. Investopedia. Web.

Frederick, R. (2022). Reducing risk with a credit spread options strategy. Charles Schwab. Web.

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Types of Credit Derivatives and Their Pros and Cons

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