Hedging Credit Risk – Covering Your Bases
Investing, simply put, can’t be done without at least some measure of risk. In many cases, the biggest returns come with the highest levels of risk while investments that are very safe usually only provide modest returns. No matter what type of investing you’re looking to participate in, hedging is a vital skill. Hedging is basically the act of making investments that will offset the risks and losses that less stable investments may carry. There are numerous hedging options and numerous reasons that you may need to think about it. Hedging credit risk is one important example and one that deserves a closer look.
If you want to understand the basics of hedging credit risk then you’ll first have to understand the basics behind credit risk itself. There are three basic types of risk you may face. Downgrade risk is the risk that a lender or carrier might actually lower the credit rating of an issuer. Credit spread risk concerns the difference between risky investments and secure ones and the chance that their spread will change at some point after purchase. And default risk is simply the risk that comes with whether or not an issuer will default on their payments. All three types are important to assess when making any financial choices.
Hedging credit risk can be done in a variety of different ways depending upon the situation at hand. A credit default swap can actually help hedge against all types of credit risk and is fairly easy to understand. It basically functions like investment insurance in which the buyer will purchase a contract with a credit protection provider. They’ll make regular payments to the provider, much like an insurance payment, and then be paid out compensation from the provider in the event of a default. It’s a simple process and one worth considering for certain investments.
Derivatives can also be utilized for hedging credit risk. A few choices exist, like binary credit options which pay back when specified negative events occur or credit spread options, options that will help offset spread risk by paying benchmark sums against the spread. No matter which option you choose – and these are only a few of the choices available – you should take the time to understand how to go about hedging credit risk in order to ensure that you’re as protected as you can be. No investment is without some risk, but you can certainly take steps to limit it.