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An Overview of the Emerging Market Credit Derivatives Market - page 2 / 7

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on standard ISDA contract documentation, frequently involve standardized contract sizes, and, in the case of the most liquid underlying sovereign credits and a limited number of blue-chip corporate credits, enjoy an active broker market with dealers quoting two-way pricing for standard contract sizes

Credit-linked notes and OTC deposits are moderately more complex products that eliminate the exposure of protection buyers to the counterparty risk of protection sellers and, as on-balance- sheet instruments, allow those investors restricted from engaging in OTC derivative transactions to obtain similar economic benefits as offered by credit default swaps. CLNs involve upfront payment by the protection seller of par value for a note, in exchange for a spread paid by the note issuer reflecting both the default probability of the reference entity and issuer creditworthiness. If a credit event occurs, the note redeems early and the investor takes delivery of a defaulted asset of the reference entity from the CLN issuer, with the investor sustaining a loss based on the reference asset’s loss.

OTC deposits are similar to CLNs, but involve the placement by the protection seller of a deposit with the protection buyer - rather than upfront payment of note principal - in exchange for a coupon incorporating the premium for default protection on a reference asset together with a spread reflecting issuer credit risk. In a credit event, the depositor typically forfeits the deposit and takes physical delivery of the defaulted underlying reference asset. OTC deposits are not Euroclearable and are not listed and are thus generally cheaper and easier to effect.

Synthetic CDO's are among the most complex EMCD products. Synthetic CDOs are typically "structured" transactions in which a special purpose entity ("SPE") is established to sell credit protection on a range of underlying assets via individual credit default swaps. The SPE in turn issues several prioritized tranches of notes to investors, with note proceeds typically invested in collateral consisting of high-quality government paper to meet contingent credit default swap payments, while noteholders (in order of seniority) receive both cash flows on the underlying collateral and premiums on the SPV default swaps. Synthetic CDO's provide an attractive way for banks and other financial institutions to transfer credit risk on pools of loans or other assets without selling the assets.

Credit derivatives may involve single name reference assets or a basket of names and can be customized to meet investor needs. Of the major products, sovereign single- name credit default swaps appear to be the most liquid. Transactions on corporate credits tend to be more customized and structured, with CLNs, OTC deposits, and structured default swaps most prominent.

The average size of trades in the interdealer market is generally $5 million, reflecting the standardization of contract sizes. Bid/offer spreads average 5-50 basis points, but during periods of market stress, bid/offer spreads can be very sizeable (e.g., 500 basis points in the case of Brazil). For some highly liquid credits (e.g., Mexico) it is generally possible to get quotes for credit default swaps from 1-10 years. By contrast, the high-grade emerging market corporate default swaps that are available are mostly only quoted at 5 years. In the event of credit default, CDS settlement typically takes place via physical delivery of the underlying reference asset (and not cash). EMCD pricing tends to closely track the underlying reference asset, with pricing for credit default swaps (the most basic EMCD) generally expressed as a premium to the spread over LIBOR at which comparable maturity bonds of the reference entity trade in the cash market (with bonds generally used to hedge credit derivative positions and dealer financing costs closely related to LIBOR).

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