CFM13360 - Understanding corporate finance: derivatives: credit risk

Managing credit risk

The actual or potential financial failure of a company can have widespread repercussions for other companies in the same group, for its suppliers and for banks and other institutions which have lent it money. The greater the company’s indebtedness, the wider the repercussions may be. There is an element of truth in the popular wisdom that if you owe your bank £1,000 and can’t repay, it’s your problem, but if you owe £1,000 million, it’s the bank’s problem.

If a company has issued corporate bonds, the holders of the bonds run the risk of not receiving interest payments on the due dates, or not receiving the principal when the bond matures. So any reduction in a company’s creditworthiness will reduce the market price of its bonds. Most quoted bonds have a credit rating assigned to them by an independent credit rating agency such as Standard and Poors. Ratings are on a scale running from AAA (virtually risk-free investments, such as government bonds) to D (bonds on which there has already been a default).

One long-established way of managing credit risk is factoring - selling trade debts at a discount to a debt factor, who then assumes the risks of non-payment or delayed payment. Debt factoring is widely used by companies of all sizes. More rarely, you may see the use of credit risk insurance - the company pays a premium to an insurer and receives a pay-out if a particular debt goes bad.

The use of derivatives to manage credit risk began in around 1992, and in recent years has been the fastest-growing segment of the derivatives market. Credit derivatives are not cheap, and only the largest credit risks will be hedged in this way. The main users are banks, insurance companies and large multinational groups.

All credit derivatives are over the counter products (CFM13050) and the exact form of the derivative contract will usually be tailored to the particular risk being hedged. This guidance gives examples of two sorts of credit derivative: a credit default swap (CFM13370), and a total return swap (CFM13380), but there are numerous other kinds.

Use of a credit derivative does not necessarily eliminate risk. There is always the risk that the counterparty to the derivative will fail, for instance if it has underestimated the risk or its hedging strategy fails, in extreme market conditions, as experienced during the 2008 financial crisis.