Risk Latte - Balance Sheets & Credit Derivatives

Balance Sheets & Credit Derivatives

Rahul Bhattacharya
Mar 03, 2005

One of the many risk management applications that has little bearing or impact on actual risk mitigation, is the use of credit derivatives to manage the balance sheet of a bank or a financial institution. Banks and financial institutions normally have (financial) assets like corporate loans, bonds, etc on their balance sheets.

The way it is done is by selling these assets to a third party, usually to another bank or a special purpose vehicle (SPV) and at the same time selling a total return swap (TRS) to retain the return of the sold assets. Since the assets are completely sold and there is no repurchase agreement the assets will no longer be on the balance sheet of the bank yet the bank will still retain the risk-reward profile of the assets, i.e. the economic benefits of the assets as well as the risks associated with them will still be there.

Truly groovy! Isn't it?

(See Satyajit Das' excellent compilation Credit Derivatives and Credit Linked Notes for more on the above subject).

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