Moorad Choudhry* goes back to basics and explains the structure and purpose of credit linked notes
Credit linked notes (CLNs) are a form of credit derivative
and, as flexible investment products, have become popular in
the structured finance market, as well as financing tools for
corporate issuers. Credit derivative instruments enable
participants in the financial market to trade in credit as an
asset, as they isolate and transfer credit risk. They also
enable the market to separate funding considerations from
Irrespective of the particular instrument under
consideration, all credit derivatives can be described under
the following characteristics:
- The reference entity, which is the asset or name on which
credit protection is being bought and sold
- The credit event, or events, which indicate that the
reference entity is experiencing or about to experience
financial difficulty and which act as trigger events for
payments under the credit derivative contract
- The settlement mechanism for the credit derivative
instrument, whether cash settled or physically settled
- (Under physical settlement), the deliverable obligation
that the protection buyer delivers to the protection seller
on the occurrence of a trigger event.
Credit derivatives are grouped into funded and unfunded
variants. In an unfunded credit derivative, typified by a
credit default swap (CDS), the protection seller does not make
an upfront payment to the protection buyer. CDS have a number
of applications and are used extensively for flow trading of
single reference name credit risks or, in portfolio swap form,
for trading a basket of reference credits. In a funded credit
derivative, typified by a CLN, the investor in the note is the
credit protection seller and is making an upfront payment to
the protection buyer when it buys the note. Thus, the
protection buyer is the issuer of the note. If no credit event
occurs during the life of the note, the redemption value of the
note is paid to the investor on maturity. If a credit event
does occur then, on maturity, a value less than par will be
paid out to the investor. This value will be reduced by the
nominal value of the reference asset that the CLN is linked to.
The exact process will differ according to whether cash
settlement or physical settlement has been specified for the
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