Why you should consider credit derivatives

On the surface, credit derivatives are no different from other products seeking to transfer risk from one party to another. The risk transferred is based upon the credit performance of corporations, sovereign entities or other types of debt obligations.

These instruments initially arose out of a demand for hedging and diversifying credit exposures, just like other forms of derivatives developed to hedge currencies, interest rates or equity risks. But they have since evolved into much more.

There are myriads of credit derivatives, ranging from the basic credit default swap (CDS) that encompasses almost 90% of the total credit derivatives market, to more complicated structures such as total-return swaps, credit-linked notes, credit-default swap options, credit-spread options and forwards, asset swaps, and synthetic-collateralized debt obligations.

We’ll focus on the most popular type of credit derivatives — CDSs (not to be confused with the Canadian Depository for Securities, a clearing organization with a completely different purpose).

Here are some charts and graphs illustrating the different attributes of CDSs.

Default protection

Source: BMO Capital Markets

OTC derivatives

¹ National amounts outstanding in trillions of US dollars (right-hand scale)

² As a percentage of the notional amount outstanding of all OTC derivatives (gross market values on left-hand scale)

Sources: Central Banks of the G10 countries and Switzerland; BIS

Single-name versus multi-name index

¹National amounts outstanding.

²Gross market values

Single-name sovereign debt

Source: DTTC

Credit default swap premia for banks in Europe and the United States¹

Bank CDS premia and expected default frequencies