Credit Default Swaps (CDS) and Credit Derivatives › Other Credit Derivatives
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While CDS dominate the credit derivatives market, several other instruments exist for trading credit risk.
Credit-Linked Notes (CLN)
A credit-linked note is a funded instrument that combines a bond with an embedded CDS. The investor purchases the note (providing funding) and receives coupon payments. If the reference entity defaults, the investor suffers a loss on the principal. CLNs allow investors who cannot enter derivatives to gain exposure to credit spreads.
Total Return Swaps
In a total return swap, one party pays the total return on a reference asset (coupons plus price appreciation) while the other pays a floating rate plus a spread. This transfers both credit risk and market risk without transferring ownership of the underlying asset.
Credit Spread Options
Options on CDS spreads allow investors to express views on credit volatility or hedge against spread movements. A payer swaption gives the right to buy CDS protection at a specified spread, while a receiver swaption gives the right to sell protection.
We'll explore structured credit products like collateralized debt obligations (CDOs) in the next chapter, which build on single-name CDS to create complex portfolios of credit risk.