Credit Derivatives

Credit derivativesderivative(s)credit are contracts whose value depends on the reliability—creditworthiness of an issuerissuer(s) or institutionprotection from credit riskcredit derivatives. This can be a company or a statestates. These derivatives have gained prominence in recent years as they were written in debt issues of issuers who could not meet their obligationsobligation and have thus protectedbuyerprotection their buyersprotection buyer. However, there have been cases where some of them have led to losses due to the decline of the underlying market instead of yielding the expected—comparatively higher—returnsreturn. These contracts can be used on the one hand to protect their holders from changes in the creditworthiness of issuers, on the other hand to give them access to higher returns than they could achieve through simple fixed income issues. In this chapter we present all types of credit derivatives, such as credit default swaps (CDSs), total return swaps (TRS) and credit spread options. As in the previous chapter we investigate how they can be used in order to hedge the credit risk that is generated by fixed income instruments that have been included in investor portfolios. After having read this chapter the reader is expected to have a very good understanding of how the credit derivatives work.