Credit default option (CDO): protection against credit deterioration

A credit default option (CDO) is a financial risk management instrument designed to provide a hedge against deterioration in the credit quality of portfolio assets. This derivative contract allows investors to transfer part of their credit risk to a counterparty, providing protection in the event of a borrower default. Let’s explore in detail how the credit default option works, its benefits, and a practical example of its use.

What is the credit default option?

The credit default option is an option contract that gives the holder the right, but not the obligation, to transfer a credit position to a counterparty if the debtor defaults by a predetermined date (an event known as a credit event). This instrument is generally a put type : the investor can exercise the right to transfer the position and receive a repayment proportional to the face value of the claim. In the event of default, the purchaser of the CDO receives an amount that compensates for the loss resulting from nonpayment.

The CDO can also take the form of a call option, which allows the holder to purchase securities at a discount in the event of the debtor’s default. In this mode, the option holder can take possession of safe securities that offset the loss incurred due to credit deterioration.

Operation of CDOs

In practice, the CDO operates by transferring only credit risk without altering the credit position itself, which continues to appear in the creditor’s assets. For example, a bank can use the CDO to protect itself from potential default on existing loans while still maintaining the relationship with the customer.

In the case of exercising the credit default option:

• In case of default: the holder can exercise the right, obtaining a refund proportionate to the value of the credit, thus mitigating the loss incurred.
• If no default occurs: the CDO lapses, and the creditor loses only the premium paid for the option.

Credit default option vs credit default swap

The CDO differs from the credit default swap ( CDS) in some peculiarities:

• The CDS requires periodic payments from the protection buyer, while the CDO involves the payment of a single initial premium.
• The CDO offers the ability to buy or sell securities at favorable prices in the event of a default event, while the CDS is primarily a continuous hedging contract for credit risk.

Practical example of credit default option

To better understand the use of the credit default option, let us consider a practical example.

Anonima SpA, rated Baa1, intends to issue €100 million in bonds with a two-year maturity, but is concerned that the spread may increase before issuance, thus increasing the interest rate demanded by investors. To protect itself, Anonima SpA purchases a three-month CDO with a target spread of 2 percent and a premium of 0.5 percent.

At the end of the three months, two scenarios can occur:

1. The spread increases beyond 2%: if, for example, it reaches 3%, Anonima SpA would be forced to pay an additional €1 million in interest. The company may exercise the CDO, offsetting the loss.
2. The spread remains the same or decreases: Anonima SpA will let the option expire and will have lost only the premium paid, while still benefiting from any drop in interest rates.

Advantages of CDOs

The credit default option offers several advantages for managing credit risk:

• Targeted protection: the option allows the transfer of credit risk only, keeping the original credit position unchanged.
• Flexibility in investment strategies: With the option to transfer default risk, CDOs offer active and flexible protection that can be adapted to different market conditions.
• Optimization of credit management: For financial institutions, CDOs are a useful tool for balancing credit risk exposure without disrupting customer relationships.

Conclusion

The credit default option is a valuable option for investors and financial institutions seeking to reduce credit risk exposure. With the ability to transfer only the default risk, the CDO allows investors to protect their portfolio and effectively manage financial risk. Although complex, this instrument is particularly useful for those who wish to mitigate risk without sacrificing return opportunities in the credit markets.

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