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Hedging Credit Risk

Credit derivatives allow separating the trading of the credit risk of assets from trading the asset itself. The most common derivatives are credit default swaps, which pay to the buyer the loss given default under default of the underlying asset. They are insurances against default risk. Credit spread products provide protection against a widening of credit spreads and offset the loss of mark-to-market value due to wider spreads. Syndication implies several risks:

• keeping a larger amount of the funds for a longer than expected time

• selling a fraction to other banks at a lower than predicted spread, if not agreed in advance.

This makes it useful to customize the size of the intermediate exposure, the term of the exposure and the spread. Credit derivatives allow customizing of all three items for the expected horizon of syndication, from inception and up to final take. Buying a protection would offset the exposure to credit risk beyond the expected horizon for distributing the loans to banks. A spread derivative would cap the spread.

The same issue arises for all uncertain exposures from committed lines of credit or from the potential exposures of the derivative portfolio of the bank. Credit derivatives serve for insuring potential excess exposures.

Trading Credit Risk

Investors look at credit derivatives as instruments for taking exposures to which they have no access, for searching yields, and for trading credit risk expectations. Investors also look at credit derivatives as providing return enhancements through the revenue of the seller. They also consider them for replicating exposures to which they have no direct access, as well as a way for increasing diversification by buying exposures that diversify away some of the risk of their concentrations, on certain industries for example.

Investors or traders also look at these instruments as providing an enhanced return when they perceive credit events as having a low probability. The "search for yield" makes credit derivatives attractive in spite of default risk.

Credit derivatives allow trading different expectations on the same risks. Default probabilities and recoveries are uncertain parameters. Internal ratings or default probability models are not necessarily reliable. Credit spreads embed expectations of default probabilities and recoveries. If different parties have different views on probabilities of default and/or on future recoveries, they can trade these views through CDSs. In practice, differing expectations translate into varying perceptions of loss rates across investors. The loss rate combines the default rate with the loss given default rate. For instance, a default probability of 1% combined with a recovery rate of 20% results in a loss rate of (1 - 20%) x 1% — 0.8%. Conceptually, the spread equals X x LGD, or the loss rate, under risk-neutral probabilities. A trader might estimate a loss rate of 1%, while the CDS price implies a loss rate of 0.6%. Such discrepancies are incentives for trading the different expectations about loss rates. The trader can see the CDS as under-pricing the risk and buys it in the hope of a gain in value if the embedded loss rate in the fee increases as expected.

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