Credit Risk in the Debt Capital Markets:

Combining securitisation techniques with credit derivatives to manage credit risk

By Moorad Choudhry

Case Summary

This is a case study of recent securitisation transactions completed in the European debt markets that highlight the use of a particular instrument - the synthetic Collateralised Debt Obligation – to manage balance sheet regulatory capital and bank credit risk. Banks and fund managers are exposed to credit risk inherent in their core business. This risk is managed by the use of synthetic collateralised debt obligations (CDO), which are vehicles designed to transfer credit risk on to other market counterparties. This is achieved by combining the technique of securitisation with instruments known as credit derivatives, which are instruments similar to insurance contracts. In this case study we focus on two CDO transactions observed in the capital markets during 2002.

 The Collateralised Debt Obligation (CDO) was a natural advancement of securitisation technology, first introduced in 1988. A CDO is essentially a structured finance product in which a distinct legal entity known as a special purpose vehicle issues bonds or notes against an investment in cashflows of an underlying pool of assets. These assets can be bonds, commercial bank loans or a mixture of both bonds and loans. Originally CDOs were developed as repackaging structures for high-yield bonds and illiquid instruments such as certain convertible bonds, but they have developed into sophisticated investment management vehicles in their own right. Through the 1990s CDOs were the fastest growing asset class in the asset-backed securities market, due to a number of features that made them attractive to issuers and investors alike. A subsequent development was the synthetic CDO, a structure that uses credit derivatives in its construction, and is used by banks and fund managers for credit risk management purposes. It is the subject of this case study.

Recommended level:

·         Up to MBA/Postgraduate·         Postgraduate students of Finance and Financial Engineering

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