TABLE OF CONTENTS Credit-linked notes are essentially securities structured to mimic closely, in funded form, the cash flows of a credit derivative. Credit-linked notes have a dual nature. On the one hand, they are analogous to traditional coupon-paying notes and bonds in that they are securities that can be bought and sold in the open market and that promise the return of principal at maturity. On the other hand, they can be thought of as a derivative on a derivative, as a credit-linked note s cash flow is tied to an underlying derivative contract.
Credit-linked notes play an important role in the credit derivatives market as they have helped expand the range of market participants. In particular, some participants are attracted to the funded nature of a CLN, either because of their greater familiarity with coupon-bearing notes or because they are prevented from investing in unfunded derivatives contracts by regulatory or internal restrictions.
To illustrate the basic workings of a CLN, we will go back to one of the simplest credit derivatives, the credit default swap (Chapter 6). Consider an asset manager who is seeking exposure to a given reference entity but who wants that exposure to be in funded form. A credit derivatives dealer may buy protection against default by that reference entity in a vanilla credit default swap and essentially securitize that contract, passing the resulting cash flows to the asset manager, who ultimately buys the newly created securities. Alternatively, the dealer may sell protection against...
