The Role Of Credit Risk In Exchange-Traded Notes

The financial crisis of 2008 underscored the role that credit risk plays in many investments. And while counterparty risk has been in the spotlight with such derivatives as credit default swaps, comparatively little attention is paid to its impact on exchange-traded notes (ETNs), a type of tracking product.

ETNs are relatively new — but rapidly growing — financial vehicles generally issued by a single bank as senior, unsecured and unsubordinated debt securities. As such, they are backed only by the full faith and credit worthiness of the issuer. Because ETNs are unsecured promissory obligations, ETN holders are directly exposed to the issuer’s credit or default risk. Unfortunately, many individual investors mistakenly ignore this risk. A possible explanation for this oversight is that investors may wrongly lump ETNs together with exchanged-traded funds (ETFs), which don’t entail credit risk because they hold the underlying assets of the index they are designed to track.

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