How credit risk can be hedged / transferred?

A tutorial on how credit risk can be hedged / transferred using the credit risk instruments. 

(Key inputs from CFA Institute Readings)

An investor faces three types of credit risk. The risk of default, credit downgrade of the debtor and widening of credit spreads on the debtor’s debt. The credit risk that the investor faces can be sold off to another party, basically like any other insurance contract. The party who assumes the credit risk (or who buys the credit risk) is called the credit protection seller. He may be willing to take this risk for several reasons. He may buy because he believes that the credit quality of the debt will improve. He may see value addition in some major corporate events like mergers or refinancing of debt at lower rates. All these would be positive credit events for the credit protection seller.

There are basically three products that transfer credit risk – Credit Derivatives.

1. Credit Options

                                                               i.      Credit options written on an underlying asset

                                                             ii.      Credit spread options

2. Credit forwards
3. Credit swaps

Credit options

1. The triggering events of credit options can be based on either
1. The value decline of the underlying asset
2. The spread change over a risk free rate
2. Credit options written on an underlying asset
1. Binary credit options provide payoffs contingent on the occurrence of a specified negative credit event
2. There are only two options

                                                               i.      Default

                                                             ii.      No default

3. If the credit has not defaulted by the maturity if the option the buyer receives nothing
4. The option buyer pays a premium to the option seller for the protection afforded by the option
5. Pay off can also be based on the credit rating of the underlying asset
6. A credit put pays for the difference between the strike price and market price when a specified credit event occurs and pays nothing if the event does not occur
2. Credit Spread Options
1. Payoff is based on the spread over a benchmark rate
2. Pay off formula

Credit Forwards

1. Their payoffs are based on the bond values or credit spreads
2. If a credit forward contract is symmetric the buyer of a credit forward contract benefits from a widening credit spread and the seller benefits from a narrowing credit spread
3. The maximum the buyer can lose is limited to the pay off amount in the event that the credit spread becomes zero

 Credit Swaps

1. It is a contract that shifts credit exposure of an asset issued by a specified reference entity from one investor to another investor
2. The protection buyer usually makes regular payments to the protection seller
3. In case of a credit event the protection seller compensated the buyer from the loss on the investment and the settlement by the protection buyer can take the form of either physical delivery or negotiated cash payment equivalent to the market value of the defaulted companies
4. CDS can be used a hedging instrument
5. Banks can use the CDS to reduce credit risk concentration
6. Instead of selling loans, banks can transfer credit risk by means of CDS