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From single names to exotics

Credit derivatives are at the heart of credit markets, yet a mystique prevails among those on the outside of the financial industry over exactly how they operate. Stephen Stonberg of Deutsche Bank examines the future of the credit derivatives market.

Stephen Stonberg

Credit derivatives lie at the heart of the structured credit market and nearly all credit derivatives are based on credit-default swaps.

These instruments are often poorly understood by outsiders. But a plain-vanilla single-name credit-default swap is a very straightforward contract. The complications arise when the swaps are embedded in larger financial structures or are linked to more than one name.

A credit-default swap works like an insurance policy. A protection buyer, most often a bank that owns a loan or bond it wants to hedge, pays an annual premium to a protection seller. In return, the protection seller commits itself to making a one-off payment if the reference credit defaults on any of its debt. The premium is calculated as a percentage of the underlying asset.

Last month, for example, it cost around 75 basis points to buy protection on Ford in a five-year contract - the most liquid maturity.

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