Credit linked notes

Rodanthy Tzani and Maria Leibholz


Credit linked notes (CLNs) are debt instruments whose payments are tied to the performance of the debt obligations of selected entities or “reference entities” – ie, they are linked to the credit quality of the reference entities’ obligations. The cashflow promised to the holder of the CLN note depends on the occurrence of pre-specified events (“credit events”) in the reference entities, specifically default within the asset pool. Depending on the transaction, the underlying portfolio can consist of a single reference entity or many.

The performance of the reference entity obligations is linked to the CLNs through a simple bilateral agreement in which one party agrees to absorb losses beyond a specified level, or through a derivative contract known as a credit default swap (CDS).11CLNs that use derivative contracts known as “total return swaps” also exist, but in this chapter we will only analyse the CLNs that use “credit default swaps” as underlying contracts. We explain both arrangements below. The opposite party to the swap (or agreement) is referred to as the swap counterparty or simply the counterparty.

The CLN structure is

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