Enron Corp – Credit Sensitive Notes
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Enron Corp.: Credit Sensitive Notes
A credit derivative is a contract that allows users to manage their exposure to credit risk. These contracts are typically bilateral contracts and are financial assets like forward contracts, swaps, or options. These derivatives are used in the case that a bank or other financial institution may be concerned that one of its customers will not repay a loan. These derivatives allow the financial institution to protect itself against some of the losses by transferring this risk to another party. Even though the institution is able to transfer the risk to another party they are still able to keep the loan on its books. There are unfunded derivatives that are bought and sold between bilateral counterparties and funded derivatives that are funded using securitization techniques.
In managing credit risk for a financial institution, the goal is to maximize its risk-adjusted rate of return. They do this by maintaining credit risk exposures that are within acceptable parameters. This credit risk management is not only important to its derivative operations but it is also essential to the long-term success of any financial institution. Because derivative operations cannot totally eliminate credit risk the management of this risk is vitally important to a financial institution. An institution must not only manage these risks well but must also choose counterparties wisely, as there can be counterparty risks as well.
Two of different approaches for managing ones credit risk would be using asset allocation and diversification. When using asset allocation to manage credit risk, you decide what amount of your total portfolio will go to each asset class. These asset classes are typically broken down on a percentage basis and are usually stocks, bond, cash and cash equivalents. This is a useful management tool because all of the asset classes respond differently to changing economic conditions. Using Diversification is another great way to manage credit risk. Diversification is when you divide the money that you have allocated to a particular asset class among different categories of investment. Diversification can allow variety to ones portfolio and allows one to manage non-systematic risk by tapping into different strengths of the asset class. Both asset allocation and diversification are great ways to manage ones credit risk because it allows someone to invest in a variety of asset classes and a variety of assets within each class. This can eliminate or greatly decrease the effects, on the entire portfolio, of one asset taking a deep plunge.
Credit derivatives have added much efficiency to asset management and credit risk management. These derivatives have the potential to improve the allocation of risks both in an individual setting and at the global level. Derivatives can be more efficient