Are you not getting returns for your investment risks? How can you manage the associated risks then? You can accept the risks, ignore them, reduce risk impact, or shift risk elsewhere. Before doing that, you must know the type of credit risk derivatives available for investors. In this article at AnalystPrep, James Forjan shares types of investment risks and their benefits and challenges that you must understand to leverage today’s market conditions.
Know Your Investment Risks
Firms were successful in coming out of the 2001-2002 economic slowdown by managing investment risks. They were also able to emerge out of the 2007-2009 recession due to credit derivatives. So, here are the types of investment risks that you must know before going forward:
Type 1: Credit Default Swap (CDS)
With CDS, you can buy a bond from a company. That company offers to compensate from an insurance company if it fails to give you the desired return. It acts as a ‘shock absorber’, provides more capital, and reveals the debtor’s financial status. However, your premium might increase unexpectedly, and the termination clause might have several loopholes.
Type 2: Collateralized Debt Obligation (CDO)
If you want to get rid of investment risks, go for CDOs. You can sell the products in the form of portfolios, mortgages, and bonds to buyers based on their risk appetite. The investment risk type allows banks to loan out more money. The disadvantage is that it can decrease borrower profile accuracy.
Type 3: Collateralized Loan Obligation (CLO)
Though quite similar to CDOs, it is a company loan. Using a linear approach, you can disburse revenues from the assets. CLOs also have the same benefits and investment risks as CDOs.
Type 4: Total Return Swap (TRS)
With the total return swap, both investors and debtors can swap credits and risks. You can own a TRS without having it in your account or keep it to earn security from possible losses. The problem is, the reduced value can give you fewer returns.
Type 5: Credit Default Swap Option
It is an option you get when you buy a CDS. You can purchase or sell the insurance on a ‘reference entity’ within a specific time frame.
Steps to Reduce Risks
- Credit risk insurance
- Margining or marking-to-market
With securitization, you can maintain a balance in the originate-to-distribute business setup.
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