Customizing Credit Risk

Tailoring and customizing exposures is a major function of credit derivatives. This helps reshaping individual and portfolio credit risk profile so that they meet eligibility criteria, for both lenders and investors.

Credit derivatives allow one to engineer the credit risk quality and spreads using baskets. First-to-default baskets have a credit standing lower than any one of the standalone assets in the basket. Therefore, it is possible to engineer any credit risk independently of what exists in the market by customizing the basket so that it has the desired credit standing. This is like creating a portfolio, but with fewer constraints since we build up the rating by assembling a small number of assets in the proportions consistent with the target credit standing. Note that such products are correlation products, as explained in Chapter 9.

Finally, customizing its own credit risk is feasible by buying credit insurance or selling it. When buying credit protection, the buyer hedges its exposure. When selling a credit derivative, the seller gains exposure without holding the underlying asset. Both CDSs and total return swaps serve for hedging or gaining exposure to the underlying credit risk.

Usually there is no need to invest cash to get a credit exposure. But replicating a credit-risky cash asset is easy with credit derivatives. An investor can invest in a risk-free asset and sell a CDS. The recurring fee from the CDS provides the compensations for credit risk, in addition to the risk-free rate. Note, however, that many credit derivative contracts impose posting collateral for mitigating counterparty risk.

Applications for Credit Portfolio Management

The customization of credit risk through credit derivatives has many applications, one of them being active credit portfolio management by banks. In general, the purposes of credit derivatives include replicating, transferring, or hedging credit risks.

If the bank holds a concentration in an industry, it is a protection seeker. It has number of choices, such as capping exposures or diversifying the loan portfolio in other industries. Credit derivatives offer additional options. Buying a direct protection for some of the assets held is a simple solution. The bank hedges a fraction of this concentration by buying credit protection. The bank can also diversify away some the risk of its portfolio by taking synthetic exposures and selling CDSs. The protections sold would provide revenue that would offset some of the cost of protections bought, while still benefiting from gains of diversification.

Transferring credit risk can be of mutual interest. Two banks, one heavily concentrated in industry A and the other in industry B, might be willing to exchange or transfer their risks to each other in order to achieve a better balance in their portfolios.

Credit portfolio managers look both for protection against risky assets and for increased diversification by selling protection against exposures that diversify some of the risk of the portfolio, while, simultaneously, increasing the return with the recurring premium received. The example provided in Section 59.4 illustrates the economics of the process.

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