Credit Derivative Mechanics
First of all, the most basic and widely used credit derivative is the credit default swap, accounting for around 50% of the total market. These swaps are mechanically very simple and an example will make it clear.
Let's say a convertible bond manager does not want to take the credit risk of XYZ convertible bond, desiring only to isolate the volatility component. She enters into an agreement as the buyer of protection to pay the seller of protection a regular quarterly payment or fee. This fee reflects the credit spread of XYZ over treasuries: if the credit of the company trades at 110 basis points over treasuries, the buyer will pay around 125 basis points per year payable quarterly. Once this agreement is made for some pre-determined time period, these are the only cash flows unless there is a credit event. A credit event is clearly defined with each agreement, but basically occurs when the company either misses a coupon payment on a reference bond or files for bankruptcy. If this occurs, the payments from the protection buyer to the seller cease and the bond is delivered by the buyer to the seller at par. If there is not credit event, but the credit spread of the company deteriorates, the price of the swap should reflect this and the buyer of protection can sell the swap out at the prevailing market. The bid-ask spread in these swaps is quite wide, so this may be somewhat nebulous. Because of this the asset swap, which is not used as readily anymore, is a superior structure (in our opinion) than the default swap. In an asset swap, the protection buyer actually delivers the bond to the seller at the outset of the agreement, but has an option to buy it back at par. In either case, the buyer of protection is not ultimately long the bond if she determines not to be, thus eliminating the credit exposure.
Because the spreads are quite wide in these derivatives, most of the activity is hedging; credit speculation is more short term in nature, so the wide spreads discourage this kind of activity. Some speculation is done by credit arbitrage funds. The buyers of protection are predominately hedge funds, like convertible or credit arbitrage funds, and banks. The sellers are banks, which are levered and probably control 70% of the market, and synthetic portfolio funds, which are not levered because the back the exposure with other assets.
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