The use of financial derivatives in Colombia has grown exponentially, both in the over-the-counter market and the organized market. This growth has produced an increase in the number of derivative instruments used by financial institutions for their clients here in Colombia. This has been seen in international markets. Among the derivative instruments in use, credit derivatives have not had much importance in the Colombian market. This is due to regulatory limitations and a lack of awareness about the product.
What are credit derivatives?
Derivatives are financial instruments whose value depends on one or more underlying factors. In the case of credit derivatives, the factor in question is the credit risk that originates from an asset. Regarding this credit derivative, those who conduct these operations may be exposed to certain risks (different from insurance). In this sense, credit derivatives can be held for coverage and speculation.
What is credit risk?
In simple terms, credit risk represents the risk of a potential breach of responsibility regarding an asset or contractual relationship. Typically, when speaking about credit derivatives, credit risk comes from non-payment of capital or interest by a debtor. However, credit derivatives can also be caused by situations that could become unfavorable for the creditor. For example, a decrease in the credit rating or the restructuring of a debt, among others.
What are credit derivates used for?
Credit derivatives offer creditors the possibility of managing their risk exposure and allow them to separate the credit risk of an asset rom the asset itself. In this way, an entity can continue to own an asset without being exposed to the credit risk inherent in owning said asset by having it covered by a credit derivative. Likewise, credit derivatives enable entities not involved in a contract or an asset to assume the risk and earn profits by it.
What are the different kinds of credit derivatives?
As with all derivatives, there are countless types of credit derivatives that vary in function according to the specifics that the parties negotiate. In any event, there are recurring credit derivatives in the market that are easily identifiable by name, such as credit default swaps and total return swaps.
What are credit default swaps and total return swaps?
A credit default swap (CDS) is used to transfer credit risk caused by non-compliance of agreed-upon conditions of an asset. As a return for assuming the risk, those who employ a CDS pay periodic commissions. On the other hand, a total return swap (TRS) is used to transfer any risk associated with an asset, not just the derivative of non-compliance (as is the case with a CDS).
Author: Juan Sebastián Peredo