What are Credit Derivatives? - YouTube

Hi and welcome back to my YouTube channel. In today's video we're going to

learn about credit and we'll learn about what credit derivatives are. Welcome back

to my channel. Today's video is mostly about credit derivatives, but we're

firstly going to start out by defining what we mean by credit. This is the first

video I'm doing in a series on credit derivatives. I will put them all together

as a playlist which you can watch by clicking on my profile and then on

playlists. Hopefully you'll find them useful. All of these videos are based on

my book Trading and Pricing Financial Derivatives, which I've linked to in the

description below. OK so firstly what is credit credit is

the trust that allows one party to obtain goods or resources from another

party where that second party does not pay immediately but instead arranges to

either pay or return those resources at a later date

Credit encompasses any form of deferred payment, examples include home mortgages,

credit card debts, corporate borrowing and government borrowing. The concept of

credit is necessary whenever something is borrowed or lent. Credit risk then is

the risk that a deferred payment agreement may be reneged on at or before

the scheduled payment. This is the risk of default and credit risk is also known

as default risk or counterparty risk. Historically debt obligations were

entered into and the counterparties to the transaction did not change

throughout the life of the loan until the debt matured. Credit risk is most

thoroughly examined at the initiation of the loan and then monitored periodically

until maturity. Loans and bonds can however be traded throughout their lives

between a variety of market participants thus the concept of credit risk expands

to bring in credit deterioration or credit improvement and not just the

binary outcomes of borrower repays or borrower defaults considerable sums of

money can be made and lost by traders through these more subtle variation

in credit quality and pricing throughout the life of a bond. Credit risk is better

defined as the risk of gains or losses arising from changes in credit quality

credit rating agencies exist provide investors an independent measure of the

credit quality of issuing firms and the individual debt instruments the largest

credit rating agencies are S&P Moody's and Fitch these companies are paid a fee

by the debt issuing entity to provide an independent credit rating which is then

shared widely with public debt market participants I might do a separate video

on credit rating agencies at some point let me know in the comments section if

you'd be interested in seeing that credit ratings can have a tremendous

impact on the price of financial instruments prior to the existence of

rating agencies investors had difficulty obtaining and processing sufficient

information about creditworthiness to make informed credit risk decisions

unlike the equities market where typically a company would have only one

equity security outstanding in public markets a company could have a wide

range of debt instruments outstanding each with different maturities different

coupons varying legal covenants ranges of collateralization and seniority of

repayment in the event of default the fact that each issue was rated

separately reduce the confusion surrounding these instruments and

greatly increase the attractiveness to investors of investing in bonds

including small investors who previously would have found this research effort

prohibitive ratings information greatly enhanced liquidity in bond markets

historically banks made loans and mortgages to companies and individuals

and typically held that risk until the maturity of balloons they funded this

with their own client deposits this introduced a series of limitations on

the loan and mortgage markets a given bank might aim to have a diversified set

of outstanding loans to companies loaning to a portfolio of companies

across industry sectors and applying strict percentage caps on loans to

individual sectors should minimize losses in the event of a significant

downturn in one industry sector the bank might mandate a maximum 10% of its loan

portfolio to mining companies for example and insist that these amounts be

spread across a number of different companies to reduce the default risk of

exposure to one company these sector loan restrictions designed to make the

bank's portfolio safer from defaults would have reduced loan availability to

individual companies the former hold to maturity loan model

constrained the bank's portfolio composition the bank would only be able

to make limited numbers and sizes of loans to companies that they otherwise

might be very confident of lending more funds to companies received fewer loans

under this model due to the bank's constraints a further drawback was the

fact that a bank might have an industry or regional expertise that it could

profitably and successfully pursue but would be restrained by industry sector

weight constraints in the portfolio the bank might have a top tier mining

industry team one that measures mining credit risk with acute precision and has

extensive local relationships with the mining community. This proficiency could

not be used to its full capacity in the hold to maturity loan environment. At

the same time there were other investors in the broader financial world who were

interested in taking on these credit risk exposures a similar effect was seen

in bank lending for home mortgages credit cards and student loans markets

this mismatch of banks ability to underwrite a far greater number of loans

than they could feasibly hold combined with a broader investor appetite to hold

credit risk help to drive the credit derivatives market so what are credit

derivatives credit derivatives are financial instruments that have payoffs

that depend on corporate or sovereign bonds or on loan portfolios as the under

instruments they transfer the credit risk from one party to another without

transferring ownership of the underlying securities the underlying securities

need not be owned by either party in the transaction the most common types of

credit derivatives are asset backed securities credit default swaps and

collateralized debt obligations I'll do individual videos on each of these

credit derivatives over the next few days securitization was developed to

ameliorate the problem of banks ability to issue larger amounts of credit than

they could hold to maturity on their own balance sheets securitization is the

process of creating securities whose value and income payments are derived

from and collateralized by a specified pool of underlying assets what were the

effects of securitization well securitization brought about numerous

changes in debt markets it allowed originators to remove loan assets from

their balance sheets which increased overall lending much faster than deposit

growth alone would have banks competed for loan mortgage credit card and bond

origination business leading to decreased borrowing costs for companies

and individuals the increased availability of credit affects demand

fur and thus the price of real estate and other assets that can be purchased

on credit when a bank made a loan and kept that loan on its books the credit

risk of the loan mattered to the long-term profitability and survival of

the bank securitization allows financial institutions to make loans that they do

not intend to keep on their books when loans are made in this manner there

is less of an incentive to accurately measure and monitor credit risk.

Originators are instead incentivized to minimize the costs associated with

qualifying the borrower and monitoring their credit risk this can lead to a

decrease in overall credit quality well that's it for now over the next few days

I will put up videos on some of the biggest credit derivatives

I will assemble them all in a playlist at the end I'll put up a video about the

pros and cons of these products and how they've changed the world we'll talk

about the role of credit derivatives in the credit crunch - don't forget to hit

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I'll shortly move to a schedule of releasing videos once a week if there's

a topic you'd be interested in hearing about let me know in the comment section

below have a great day bye

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