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Category: Risk Management in Banking

Sovereign risk has grown with the exposure of emerging markets. Country risk is somehow hybrid in nature. It can be an economic crisis, a currency crisis or a political crisis. Economic crises tend to increase the default rate of all private obligors residing in the country. Another aspect of country risk is inconvertibility risk.

Convertibility products address the ability to make payments in another country. Such events look like political events, but their consequences are equivalent to a credit event. Credit derivatives hedge currency inconvertibility and transfer risks. The agreement provides protection for a determined period. The protection buyer pays a premium. If there is no currency inconvertibility during the agreed period, the contract terminates without benefit to the protection buyer. If there is a currency inconvertibility event, the protection buyer gets the face value of the funds in hard currency. In return, the protection seller gets property to the face value in soft currency. The simplest reference for the exchange rate is the one prevailing at a recent rate. Receiving the strong currency effectively protects the owner of the weak currency from not being able to get the money back. The protection seller should have some local usage of the inconvertible currency to make a deal. Investors in the country might have such a position.

Other derivatives address different dimensions of country risk. Sovereign default has remained scarce, but sovereign crises have happened rather frequently. Derivatives use currency exchange rates as underlying asset.

Applications of Credit Derivatives

The applications of credit risk derivatives stem from two main features:

• The capacity to trade credit risk only, in isolation.

• The ability to do so in a liquid fashion, with low transaction costs, since these are off-balance sheet.

Credit derivatives offer innovations beyond hedging credit risk. They allow us to hedge credit risk, trade, customize and create synthetic exposures. The demand for protection is only one side of the coin. Investors have new opportunities to invest, enhance their revenues and arbitrage the credit risk market. They play a double role: selling the protections demanded by others and taking advantage of new investment opportunities. Credit derivatives tailor risk and reshape income, so that the economics of such transactions extend to the whole risk-return profile. The five main applications are:

• Trading credit risk. The off-balance sheet nature of the transaction allows trading credit risk whenever expectations of future credit risk differ.

• Hedging credit risk. Hedges match the credit risk of actual assets with the mirror credit risk of a credit derivative. There were no hedging instruments before credit derivatives, other than classical insurance contracts (in addition to clauses embedded in loan contracts). Furthermore, credit derivative hedges apply to single assets, baskets of assets or the entire banks portfolio.

• Active portfolio management. Credit derivatives provide many features necessary to actively reshape the risk-return profile of a portfolio.

• Customizing credit risk. Customization applies to exposure, term structure and credit quality. Customization requires combining actual asset risk profiles with the risk profile of derivatives, resulting in a reshaped combined risk profile. The ability to leverage the exposure by using a notional different from the actual asset value magnifies this capability.

• Creating synthetic exposures and taking credit exposures. The buyer of a credit derivative can take synthetic exposures that would otherwise be out of his direct reach. The seller of a protection gets the exposure to the underlying risk. Instead of buying cash the exposure from a bank, he purchases, for example, a total return swap. On the other side of the deal, the lender hedges his risks.

The sections of this chapter detail the benefits and drawbacks of these five types of applications of credit risk derivatives.

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