If we are going to the basics, why not go a step further back and look at derivatives themselves. A standard definition of derivative, at least in some regulation and accounting directives defines derivative as a contract with three essential features. First, the value of this contract depends on an underlying, which can be an index, spot value, events et al. The second feature is that it is settled at some future date. And finally, derivatives involve little or no initial cash flows.
So we know what a derivative is. Let us look at credit derivatives (CreDs) then. Well a derivative in which the underlying is a credit exposure or a credit index or the risk involved is credit related, with the second and third characteristic of a derivative is a CreD. Let us try to look at the derivatives type tree then. It should be something like this:-
Financial derivatives are our equity/interest rate/forex forwards, futures, options and swaps. I guess most people are aware of these products and they are certainly not the focus of this blog. In ‘other derivatives’ we may have derivatives whose value depend on something other than a financial or credit related underlying. For example weather. Who knows in India we may have ‘cricket derivatives’. A dream product can be a CMS like structure, batting average of Sachin in 2006-07 minus average of Saurav in 2006-07 times 10 mio.. I wonder if that would become a legal way of betting in India.
Anyways, coming back to the main issue - CreDs. Under CreDs, we have Credit Default Swaps (CDS). Then we have options on credit underlying, mainly credit options and credit spread options. The two are slightly different. Then CLNs or credit linked notes which are not very different from CDS but put as a different category on populist grounds. Then you have Total Return Swaps, where both market and credit risk is hedged (NB TRS doesn’t hedge counterparty credit risk). Then there are Collateralized Debt Obligations (CDOs). CDOs are fast becoming an asset class in themselves and are becoming increasingly exotic and complex. And then finally you have exotic CreDs which are nothing but weird combination of basics CreDs, structured in a form to supposedly suit the requirements of the client but actually to dupe her.
Poof! That was pretty lengthy. But now that we have a broad classification in place, the blocks from the tree can be picked up and discussed without losing the BIG picture.
