Credit instrument
| Credit instrument |
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| See also |
Credit instrument it is contracts in financial area between two parties or more regarding a right to payment of money. Those monetary contracts allow users to handle their exposure to credit risk. It could be currency in cash, share - evidence of an ownership interest in an entity or bond what it means a contractual right to receive or deliver cash.
Types of credit instrument
In literature it is distinguish several types of credit instrument for instance (A. N. Bomfim, 2015, s.5-9):
- Single-Name Instruments - include protection against insolvency. Example of Single-Name Instruments are the credit default swap (CDS), asset swaps,total return swaps (an investor without buying and owning the asset or the index receive all the cash flows associated with a given reference assets or financial index), spread and bond options (Spread and bond deviate of norms which are based on final payoffs are essentially tied to default event involving the reference entity. Spread options payoffs are specified in terms of the performance of a reference assets relative to that of another asset. Bond options we can buy or sell it in a good time of their price).
- Multiname Instruments - contracts which allow to mixed credit risk associated thanks to portfolio of defaultable securities instead to dealing in each of security portfolio separately. For example, first-to-default basket swap or portfolio default swap.
- Credit-Linked Notes (CLN)- can be assume that it is regular debt obligation with an embedded credit derivatives.
- Sovereign vs. Other Reference Entitle - can reference in private sector (for example corporates) or sovereign nation. For instance agrees for sovereign debtors can include moratorium and debt repudiation as credit events, whereas contracts that reference corporate debt are not allowed similar demeanour.
Another Types of credit derivatives: Repackaging Vehicles; Synthetic CDOs; CDS Indexes; CDS on Credential Mortgages and Subprime Residential Mortgages(A. N. Bomfim, 2015, s.43-148).
Macroprudential instruments
Macroprudential instruments should introduced to reducing risk of systemic, in two types over time or across institutions and markets. Using macroprudential instruments (C. H. Lim, A. Costa, F. Columba,P. Kongsamut, A. Otani, M. Saiyid, 2011, s.4-5)
- Single versus multiple - use of different instruments can be more effective and shows different aspects of the same risk
- Broad-based versus targeted - Usage of differentiating transaction makes more precise and more effective the instruments are.
- Fixed versus time-varying - in case where we diversificate instruments in different part of the cycle, it is possible to achieve more effective financial cycle.
- Rules versus discretion - clear advantages and effective are rules-based adjustment like a dynamic provisioning
- Coordination with other policies - More effective is to mixed instruments with monetary or fiscal policy tools. It caused reinforcement reaching goals.
Examples of Credit instrument
- Loan: A loan is a type of credit instrument where a financial institution (bank, credit union, etc.) agrees to provide a certain amount of money in exchange for repayment of the loan and any accrued interest. This credit instrument is typically used to finance large purchases, such as a car or house, but can also be used for smaller items such as furniture or appliances.
- Credit Card: A credit card is a type of credit instrument that allows the user to make purchases and pay for them in installments. This type of credit instrument is typically provided by a bank or other financial institution and allows the user to make purchases without having to pay for them in full up-front.
- Mortgage: A mortgage is a type of credit instrument that allows the borrower to purchase a home. The borrower agrees to make payments on the loan, plus interest, over a period of time until the loan is paid off, at which point the borrower owns the home outright.
- Line of Credit: A line of credit is a type of credit instrument that allows the borrower to access a predetermined amount of money, up to a certain limit, over a period of time. This type of credit instrument is typically provided by a bank and is usually secured with collateral, such as a savings account or stock portfolio.
Advantages of Credit instrument
Credit instruments are a useful tool for managing credit risk in financial markets. The following are some of the advantages of using credit instruments:
- Credit instruments can provide a way to hedge against losses, as they can be used to transfer the risk associated with a loan or other financial transaction.
- Credit instruments can also help to reduce the cost of borrowing, as they can be used to secure a lower interest rate or other form of financing.
- Credit instruments can also help to facilitate the purchase of goods and services, as they can be used to provide a form of payment that is secure and reliable.
- Credit instruments can also be used to manage liquidity, as they can be used to convert assets into cash quickly and efficiently.
- Credit instruments can also be used to help manage risk by allowing the lender to diversify their portfolio of investments.
- Credit instruments can also be used to help manage liquidity, as they can be used to provide a form of payment that is secure and reliable.
Limitations of Credit instrument
Credit instruments can be extremely useful tools for managing credit risk, but there are some limitations that users should be aware of. These include:
- The cost associated with entering into a credit instrument can be quite high. Depending on the type of instrument used and the credit rating of the borrower, fees such as transaction fees, legal fees, and other costs can add up quickly.
- The terms of a credit instrument can be complicated, making it difficult for users to fully understand the risks and benefits. As a result, users should seek professional advice before entering into any credit agreement.
- Credit instruments are often subject to changes in market conditions. This means that if the market changes drastically, the terms of the instrument may be altered to reflect the new environment.
- Credit instruments are often long-term agreements, so users should be prepared to commit to the terms of the instrument for a long period of time.
- Credit instruments may not always be ideal for certain types of transactions. For example, if a business is looking to finance a short-term project, a credit instrument may not be the best choice.
A Credit instrument is a financial contract between two or more parties that specifies the right to receive or deliver cash, securities, or other resources. There are several approaches to Credit instrument that can be used to manage credit risk exposure, including:
- Cash instruments, such as currency or bank deposits, which are generally the most liquid form of credit instrument.
- Securities, such as stocks and bonds, which are contractual rights to receive or deliver cash or other resources.
- Derivatives, such as futures and options, which are contracts whose value is derived from underlying assets.
- Credit default swaps, which are insurance-like contracts between two parties that provide protection against the risk of default on a debt obligation.
In summary, Credit instruments are financial contracts between two or more parties that enable users to manage their exposure to credit risk. Cash instruments, securities, derivatives, and credit default swaps are all examples of Credit instruments that can be used to protect against the risk of default on a debt obligation.
References
- Bomfim, A. N. (2015), Understanding credit derivatives and related instruments. Academic Press.
- Kalemanova A. , Mayer B. , Zagst R., (2015) Asset Allocation with Credit Instruments, Munich University of Technology.
- Lim, C. H., Costa, A., Columba, F., Kongsamut, P., Otani, A., Saiyid, M., (2011), Macroprudential policy: what instruments and how to use them? Lessons from country experiences. IMF working papers, 1-85.
Author: Karolina Knapik
