Credit Risk Documentation (Specific to Credit Derivatives)

The proper assessment of credit risk, default or monitoring can be done first through documentation. This is certainly most true for credit derivatives. Clear documentation will help determine for example, when the counterparty has defaulted. In the case of general derivatives, a standardization procedure works well with respect to resolving problems with formulation and interpretation of contract details.

Break clauses refers to a termination by either party, subject to certain pre-agreed conditions. Say a derivative with a ten-year period, either party may seek a break at 3, 5 or 7 years. This is usually done to renegotiate the terms of the contract. The break clause may be put into action by either party if the mark-to-market exposure exceeds a point or either party’s credit rating falls below a certain level. Concerns arise therefore from either party in terms of if the contract will reach fruition; if both parties will agree on the termination value. Counterparties are affected by replacement values and therefore issues may arise. Detailed documentation can assist in these situations.

With regards to a downgrade a rating trigger must be mapped to the corresponding credit protection product. If not, the counterparty benefits from this.

The ISDA has published “2003 ISDA Credit Derivatives Definitions”. The Definitions provide the basic framework for the documentation of certain privately negotiated credit derivative transactions. The counterparties may adapt or supplement the standard provisions provided in definitions according to the specific terms agreed upon by the parties in each transaction. These definitions help in smooth and efficient functioning of the credit derivatives market by providing a common set of terms for parties to use in preparing Confirmations for privately negotiated transactions.

Below is a list of books related to credit derivatives documentation.

Credit Derivatives Definitions