Any investment comes with a certain level of risk. When lenders offer credit to consumers or businesses, the risk involved is that the borrower will not be able to repay their loan. To help offset this, hedges are investment positions that can offset the risk. These hedges can be constructed from a wide range of different financial tools, such as stocks, mutual funds, futures contracts, or swaps. When hedging credit risk, lenders will look at the ability of a debtor to be able to make a payment. To manage this risk, they can use credit analysis techniques and use derivatives as the main form of hedging.
In addition to banking institutions, another group that will utilize hedging credit risk strategies is corporations. They need to estimate how likely it will be that defaults or losses can occur should there be a default on any credit or unexpected event. These credit losses can be calculated using statistics, for a set period of time in the future. These losses can then be factored into the pricing of products, as a normal part of doing business. This is a good way to hedge risk, because it can protect against any unexpected events or losses. If the losses do not occur, then the corporation comes out ahead.
There are three main forms of hedging credit risk with the use of derivatives. A credit default swap is one option. This is a contract that a buyer purchases, and they can then make regular payments for credit protection. If there is a default, the buyer then receives money from the seller as a result. It can be looked at as an insurance policy. Another option is a total return swap, which is a way for one side to make payments based on an amount of total return that comes from a specific asset. On the other side, they will make payments.
Finally, a credit linked note is another tool used in hedging credit risk. With this option, investors will receive a higher yield if they are willing to accept that risk exists. Investors can be paid either a fixed or floating rate of return throughout the period of this note. When the time period expires, they then can receive the level amount or a recovery rate value if some default has occurred. Hedging can be beneficial because it removes the risk of default, but in the end it can also reduce your return on any investment, so that is something to take into consideration.