Cash & Loans Advice Blog

Protection related to credit events

CDS are used to transfer the credit risk of a reference entity from one party to another. One party (the protection buyer) pays a periodic, fixed premium to another (the protection seller) for protection related to credit events on the reference obligation. If there is no credit event, such as default during the life of the swap, these premiums are the only cash flows . If a credit event occurs the protection seller is obliged to make a payment to the protection buyer. For physically settled contracts, following a credit event, the protection buyer delivers the defaulted reference obligation.

Cash settlement (par minus market value) is the alternative to physical settlement and is used less frequently in standard CDS but overwhelmingly in tranched CDOs. The 2003 ISDA definitions further clarify the three types of credit events:

• Bankruptcy
• Failure to pay
• Restructuring.

Just like cash bonds or loans, CDS transfer credit risk. To remove the interest rate component of a cash bond, a synthetic floating-rate note can be created via an asset swap which eliminates the duration and convexity exposure of the cash bond. An unfunded position in the bond would have to be financed in the repo market. A CDS is equivalent to a financed purchase of a bond with an interest rate hedge (selling protection through a CDS or buying a corporate bond, asset swapping the coupon to floating and financing the holding in the repo market).

Making the right online credit decisions

In 1996, General Electric (GE) pioneered the use of an extranet (a closed network for use by people external to the organisation) in its lighting division to develop effective business-to-business relationships. The lighting division established a global network, linking with suppliers worldwide, to enable the company to complete its purchasing transactions more quickly. A feature of the extranet, known as the trade processing network (TPN), allowed GE’s many international suppliers to download GE product specifications and communicate with the company via a secure, encrypted software link over the internet. The benefits of this approach for the lighting division were swift and significant: the cycle time in the purchasing process was reduced, enabling more efficient production and inventory management. GE suppliers continued to become an integrated part of a global community. Furthermore, TPN was employed in seven other GE business divisions as well as being licensed to other manufacturers to use with their suppliers.

In contrast, a survey of websites in 2000 found that 40% of e-mail questions went unanswered. Only 16% of sites followed up with a marketing offer to customers that had purchased from them in the last 30 days, and of these, only 2% were personalised. Other surveys suggest that as many as 60% of people using the internet believe that giving out personal information is “generally unsafe”. Many businesses now recognise the commercial importance of ensuring that their websites are safe and secure, and are seen to be so by their customers.

The best online credit decisions

The best online sales decisions blend past experience and existing resources with the dynamism and invention of the internet. One useful principle is to use the flexibility of the internet, effectively testing new decisions and ideas. The technology and culture of the internet enable one approach to be tested for a short period before making improvements.

Ten things determine the success of online business activities, some or all of which are useful to consider when deciding how to develop online sales:

• Content
• Communication
• Customer care
• Community and culture
• Convenience and ease
• Connectivity (connecting with other sites as well as with users)
• Cost and profitability
• Customisation
• Capability (dynamic, responsive and flexible)
• Competitiveness

Each of these exerts a significant influence on the success of online activities. Some are more important than others, depending on the organisation’s stage of development, brand strength and competitive position. Some are always important, such as capability and convenience, whereas others can assume a greater significance at a particular time (competitiveness, although always in the background, may assume a sudden and striking relevance).