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THE BACKGROUND

What is credit?

Two main factors determine the value of bonds and loans. One is the prevailing rate of interest - usually set by a central bank such as the US Federal Reserve or the European Central Bank. The interest paid on bonds or loans may rise or fall in line with prevailing interest rates or it may be fixed - in which case the value of the asset rises and falls as interest rates change. The other factor is credit risk, the risk that the borrower is unable or unwilling to make payments as they become due.

When the government of France or the United States issues bonds, the credit risk involved is minimal. What investors need to worry about is interest rates. But when companies or emerging market governments borrow, investors are exposed to both interest rate and credit risk.

The credit market, as defined in this primer, is the business of trading, structuring and investing in the credit risk of large companies, emerging market countries and structured finance bonds, either through cash instruments (bonds and loans) or through credit derivatives.

What is structured credit?

The term 'structured credit' has several different meanings. By one definition, it refers to a wide range of credit-derived products, including CDOs and credit derivatives. An alternative definition, and the one used in this primer, is that structured credit refers to tranched credit products.

By this definition, a fully distributed cash CDO is a structured credit product but it is not a credit derivative. Single name credit default swaps are credit derivatives but not structured credit products. And single-tranche credit derivatives, index tranches and nth-to-default baskets fall within the definition of both structured credit and credit derivatives.

What are credit derivatives?

Credit derivatives were first traded sporadically at the end of the 1980s but it was not until the early 1990s that a real market for these products began to emerge. In the late 1990s and the first half of the next decade, credit derivatives grew rapidly to achieve a central role in the financial markets.

The purpose of a credit derivative is to transfer only the credit risk of a borrower and not the associated interest rate risk. The fact that credit risk can be traded in isolation makes credit derivatives a very powerful tool.

The main types of credit derivative products are single name credit default swaps, credit derivative indices, index tranches, synthetic CDOs and CPPI.(See the Glossary).

Unlike bonds and loans, which are financial contracts between a borrower and a lender, credit derivatives are contracts between any two counterparties which reference a specific borrower (the 'reference entity'). Very often neither counterparty is a lender to the reference entity. The reference entity is rarely involved in the trade and usually has no reason to know that the credit derivative contract exists.

All credit derivatives traded to date (mid-2006) have been over-the-counter (OTC) derivatives. Unlike many equity or commodity options and futures, they are not traded on an exchange but are simply private contracts between two counterparties - one of which is usually a dealer (also called a market maker).

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