CREDIT RISK of DERIVATIVES
Summary
- Credit analysis should play an increasing role in equity investment
- Investors should appreciate that in the majority of cases derivatives are
contracts and not assets
- Shares enjoy a certain element of standardisation, but by their very nature
derivatives - particularly OTC - are very flexible; thus the importance of
carefully analysing separately each derivative investment
convertible bonds & warrants
- Unlike exchange traded futures/options and OTC options, corporate issued
convertible bonds and warrants are assets and not contracts.
- Convertible bonds carry the same credit risk as that of straight bonds: if the
company goes bust, the bonds may not be redeemed.
- Warrants are similar to shares, where credit risk is not really an issue.
exchange-traded futures and options
- futures brokers deal with clients as principals and not as agents, thus the
investor takes the credit risk directly of the broker and not the exchange
itself
- the futures exchange safeguards are to protect itself and its member
brokers, not directly clients; a client compensation fund may exist, but this
will usually be far smaller than any reserve fund used to bail out member
brokers
otc options
- the investor takes the credit risk purely of the direct issuer of the contract
- contract terms should be scrutinised as these will not usually be
standardised
- careful distinction should be made between exchange traded options and
OTC options listed on exchanges
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