What is Credit-linked Notes?

credit linked notes and credit default swaps,they are used to insure against business risks. But i need details of their working.please help

What is Credit-linked Notes?
A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider.





It is issued by a special purpose company or trust, designed to offer investors par value at maturity unless a referenced credit defaults. In the case of default, the investors receive a recovery rate.





The trust will also have entered into a default swap with a dealer. In case of default, the trust will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed on to the investors in the form of a higher yield on their note.





The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available. The CLNs themselves are typically backed by very highly-rated collateral, such as U.S. Treasury securities.





A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).





Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.

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