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Introduction to Credit Derivatives

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This chapter explores the concept of credit risk, and why understanding how credit risk is derived can help your business flourish, both from a borrower and a lender standpoint.

A Disease Known as Credit Risk

The following situation may sound familiar: A while ago, you lent money to a friend and the time has come for the friend to pay you back. You already worry, though, that your friend won’t be able to pay back the loan. The idea that you might have to remind him is unpleasant; it makes you uneasy, queasy, almost to the point of nausea. Well, we are here to inform you that you have just been infected with the Credit Risk virus. And you won’t be cured until the money is safely returned.

In the modern world, this is a virus as ordinary as the common cold. It does not limit itself to you or your friends. Credit risk touches anyone that extends a loan or has money due. It affects banks that offer loans to individuals, companies that give credit lines to their customers, and investors that buy corporate bonds from companies. In each of these examples, the credit taker—the individual, the clients, or the company— may not return the money or pay back the loan.

Put simply, credit risk is the risk that a borrower won’t pay back the lender.

Of course, this should be expected when lending money—and it should be just as expected that the lender wants to evaluate how "safe" or credit worthy the borrower is. Banks run background checks on borrowers to avoid ending up with—in industry terms—a non-performing or bad loan. For instance, if an individual applies for a house purchase loan, the bank will automatically verify the applicant’s history of bank loans. This check of a person’s credit worthiness answers several questions: Has he taken loans earlier, how big were they, and did he pay them back on time? Furthermore, are there assets that the bank can use as substitutes for payment—also known as guarantees or collateral—if the person does not pay back the loan? How valuable is the collateral, or rather, how much of the bank loan can the collateral pay back (sometimes referred to as the recovery rate)?

The same type of evaluation takes place if the borrower is a company. Picture a corporation that wants to build a new steel factory and applies for a loan to finance the factory. The bank will want to learn the history of the company. Is it knowledgeable about the steel industry? Has it built steel factories before? Does it have a credit rating from an external agency, such as Standard & Poor’s or Moody’s? What guarantees can it provide? A good bank will discuss all these issues before deciding whether to grant the steel factory a loan.

Credit risk is not limited to banks and their borrowers. Companies themselves are exposed to credit risk when they trade with customers and suppliers. In business, almost all companies are exposed to credit risk, simply because they do not ask for direct payments for products or services. Think of the standard payment program for a new car: The car dealership carries a credit risk, which slowly diminishes until the car is paid in full. Or, think of the typical company that ships its products with a bill specifying 30 days net payment: During those 30 days, and until payment has been made, the company is exposed to credit risk. As a result, companies often have to rely on its clients and trust their credit worthiness.

Companies also have to pay attention to their own credit risk. If the actors in the financial markets—such as banks and bond investors—believe that a company’s credit worthiness has dropped, they will charge more for lending money to that firm, because they now have to factor in a higher perceived uncertainty and risk. For the firm, this means that its borrowing cost rises, as lenders demand a higher interest on loans than before. In other words, credit risk is a "disease" that can hit a company both as a lender and as a borrower.

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