Allow one party to buy protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
The protection buyer pays a premium for the protection, and the protection seller agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified credit events.
Grants the buyer the right, but not the obligation, to purchase a bond during a specified future “exercise” period at the contemporaneous market price and to receive an amount equal to the price implied by a “strike spread” stated in the contract
CREDIT SPREAD – the difference between the yield on the borrower’s debt (loan or bond) and the yield on the referenced benchmark of the same maturity
Is essentially a funded credit default swap which transfers credit risk from the note issuer to the investor.
The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.
If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.
Example… Refer to the Steel company case again
Bank A would extend a $1 million loan to the Steel Company.
At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.
If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.
Exhibit Bank A Institutional investors Steel Company $1 Million fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate $1million 500b p Steel Company