Enron Corp. Case

Enron Corp.

1. In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on a financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. If the buyer of the derivative believes the underlying bond will go bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100 fold profit.

2. A credit derivative is a wager, and the reference entity is the thing being wagered on. Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have anything else to do with the race, the person buying the credit derivative doesn't necessarily own the bond (the reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or collateralized debt obligation (CDO) in question will default (go to zero value).

3: The standardized approach: exposures to various types of counterparties will be assigned risk weight based on assessments by external credit assessment institutions.

The foundation internal rating-based approach: banks, meeting robust supervisory standards, will use their own assessments of default probabilities associated with their obligors.

The advanced internal rating-based approach: banks, meeting more rigorous supervisory standards, will be allowed to estimate several risk factors internally.

4. As stated in the question 1, credit derivatives are financial instruments whose value is derived by credit risk. Financial institution and investors can use credit derivatives to reduce credit risk. Credit derivatives like an insurance to protect financial institution and investors from credit risk movement. Take an example in credit option, one of credit derivatives, bond investors pay money to buy insurance to hedge the value of corporate bond. If the bond defaults, the payoff of the insurance would offset the loss from the bond. If there is no default, the investors still receive payments as the bond stated. Regarding to credit risk movement, credit derivatives give an opportunity to investors to offset their loss, which are caused from credit risk movement. For example, if the credit risk of bond issuer increases, which causes credit risk premium increases and the bond price decrease, investors would get payoff from credit derivatives to offset their loss caused from bond issuer's credit risk increasing. Financial institutions and investors use credit derivatives to hedge against adverse moves in the credit quality of the investment.