DERIVATIVES FROM A HEALTH CARE POINT OF VIEW
By Melvin J. Howard
The concept of derivative is to create a contract that derives from an original contract or asset. For example, stock market derivatives are contracts that are settled based on movements in prices of stocks, without transferring the underlying stock. Similarly, a credit derivative is a contract that involves a contract between parties in relation to the returns from a credit asset, without transferring the asset as such. As you may notice this is a financial instrument that is used by financial institutions. It has now been expanded to a number of industries. As I mentioned in my previous postings health care is my main focus I think in order to properly serve as a hospital administrator or CEO. It is important that one has some information on the different methods of financing and mitigating risks of their health care facility.
What is a credit derivative? A credit asset is the extension of credit in some form: normally a loan, installment credit or financial lease contract.
Every credit asset is a bundle of risks and returns: every credit asset is acquired to make certain returns on the asset, and the probability of not making the expected return is the risk inherent in a credit asset. There are several reasons due to which a credit asset may not end up giving the expected return to the holder: delinquency, default, losses, foreclosure, prepayment, interest rate movements, exchange rate movements, etc. A credit derivative contract intends to transfer the risk of the total return in a credit transaction falling below a stipulated rate, without transferring the underlying asset. For example, if bank A enters into a credit derivative with bank B relating to the former's portfolio, bank B bears the risk, of course for a fee, inherent in the portfolio held by bank A, while bank A continues to hold the portfolio. The motivation to enter into credit derivatives transactions are well appreciable. The above example has depicted credit derivatives being a bilateral transaction - as a sort of a bartering of risks. As a matter of fact, credit derivatives can be completely marketable contracts: the credit risk inherent in a portfolio can be securitised and sold in the capital market just like any other capital market security. So, any one who buys such a security is inherently buying a fragment of the risk inherent in the portfolio, and the buyers of such securities are buying a fraction of the risks and returns of a portfolio held by the originating bank. Thus, the concept of derivatives and securitisation have joined together to make risk a tradable commodity.
A definition of credit derivatives: Credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties (the protection sellers).Types of credit derivatives: The easiest and the most traditional form of a credit derivative is a guarantee. Financial guarantees have existed for thousands of years. However, the present day concept of credit derivatives has traveled much farther than a simple bank guarantee. The credit derivatives being currently used in the market can be broadly classified into the following:
Total return swap: As the name implies, a total return swap is a swap of the total return out of a credit asset against a contracted prefixed return. The total return out of a credit asset can be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements, exchange rate fluctuations etc. Nevertheless, the protection seller here guarantees a prefixed return to the originator, who in turn, agrees to pass on the entire collections from the credit asset to the protection seller. That is to say, the protection buyer swaps the total return from a credit asset for a predetermined, prefixed return.
Credit default swap: Credit default swap is a refined form of a traditional financial guarantee, with the difference that a credit swap need not be limited to compensation upon an actual default but might even even cover events such as downgrading, apprehended default etc. In a credit default swap, the protection seller agrees, for an upfront or continuing premium or fee, to compensate the protection buyer upon the happening of a specified event, such as a default, downgrading of the obligor, apprehended default etc. Credit default swap covers only the credit risk inherent in the asset, while risks on account of other factors such as interest rate movements remains with the originator.
Credit linked notes: Credit linked notes are a securitized form of credit derivatives. The technology of securitisation here has been borrowed from the catastrophe bonds or risk securitization instruments. Here, the protection buyer issues notes. The investor who buys the notes has to suffer either a delay in repayment or has to forego interest, if a specified credit event, say, default or bankruptcy, takes place. This device also transfers merely the credit risk and not other risks involved with the credit asset.
