Credit Derivatives Pricing and Applications

180350

740586

893

1581

1189

1952

4799

0

1000

2000

3000

4000

5000

6000

1997 1998 1999 2000 2001 2002 2004

Bill

ions

of U

SD

1997/1998 survey 1999/2000 survey 2001/2002 survey

Exhibit 11.1: Global Credit Derivatives Market Excluding Asset Swap

Credit Derivative Products

Credit default swap Credit linked Noted CLOs Total return swap Credit spread forward Credit spread Option

Credit Spread

The spread of default-free bond with that of the defaultable debt instruments provides valuable information in the following ways.

-Conveys Probability of default -As a leading economic indicators -As an efficient allocator

Implication of spread

Using the spread the Central Banks analyze the interdependence between:

The Treasury bonds, corporate bonds and money market debt to gain insight into responses to monetary policy changes.

For example, widening or tightening spread is the credit market response to ration credits to the less credit (good credit) worthy issuer.

Application of Credit Derivatives

Credit derivatives enable the parties to reduce credit exposure without physically removing assets from the balance sheet.

However, transaction on credit derivatives is confidential and does not require notification of the customer thereby separating fiduciary relationship with that of the risk management decisions.

Credit Event/Default Swap

This is an over the counter contract between two parties, where party A the buyer of the protection pays an annuity (insurance premium) to the party B, the seller of the protection on the risky debt instrument “reference asset” issued by party C.

Protection seller (Party B) is obligated to pay the face value of the reference asset/assets triggered by the events as outlined in the ISDA master agreement contract.

Uncorrelated conterparty

Exhibit 11.4 Credit Default Swaps Cash Flows

1 2 3 4 5

Time (Year)

US

Dol

lars

Max [Par(1-R)!ISAD events, 0]

Cash Flow of Five-Year Credit Default Swap

Party A Protection

Buyer

Party B Protection

Seller Receive face value of debt issued by Party C contingent on its default

Pay annuity of [80 bps x $10 million]

Triggered Events

The credit event(s) that obligates the seller of the CDS to pay the buyer may include some or all of the followings:

- Bankruptcy -  Counterparty failure to pay -  Material restructuring debt - Capital control/moratorium - Obligation acceleration or default - Downgrade Receivership

Pricing CDS

The price of CDS can be estimated as a portfolio of long position at:

the frn at LIBOR + q bps plus a long position on the CDS on the same bond at the cost of z bps

to produce a synthetic default free frn as follows.Long frn+ long CDS=synthetic risk free frn Suppose the bid/offer spread is 1/8 on the LIBID/LIBOR, and TED

is 12.5 basis points resulting at a default swap spread of z as follows:

LIBOR + q – z = LIBID - TED LIBOR – LIBID = z-q- TED z = q +25 bps z = 175 bps

Credit Default Swap Quotation (A1/A)

Term BidOffer Ref obligation XYZ 7.125% 1/31/ 10

5 yrs 55 65 Payout/Settlement Physical, Par Versus Delivery, January 31, 2001

Probability of Default

Pdf = Pd + long put

Where Pdf and Pd are default-free and risky defaultable debt.

PD = [1- (Pd / Pdf )] (1- R)

PD = [1-(75.08/78.35)] (1- R) = .041

: Moody’s Average 1-year credit ratings transition matrix, 1920-1996.

Rating from:

Aaa Aa A Baa Ba B Caa-C Default WR

Aaa 88.32% 6.15% 0.99% 0.23% 0.02% 0.00% 0.00% 0.00% 4.29%

Aa 1.21% 86.76% 5.76% 0.66% 0.16% 0.02% 0.00% 0.06% 5.36%

A 0.07% 2.30% 86.09% 4.67% 0.63% 0.10% 0.02% 0.12% 5.99%

Baa 0.03% 0.24% 3.87% 82.52% 4.68% 0.61% 0.06% 0.28% 7.71%

Ba 0.01% 0.08% 0.39% 4.61% 79.03% 4.96% 0.41% 1.11% 9.39%

B 0.00% 0.04% 0.13% 0.60% 5.79% 76.33% 3.08% 3.49% 10.53%

Caa-C 0.00% 0.02% 0.04% 0.34% 1.26% 5.29% 71.87% 12.41% 8.78%

Average Recovery Rates on U.S. Corporate Bonds

Class Mean(%) Standard Deviation

Senior Secured 52.31 25.15

Senior Unsecured 48.84 25.01

Senior Subordinated 39.46 24.59

Subordinated 33.17 20.78

Junior Subordinated 19.69 13.85

Argentina Sovereign Spread

Fixed-Rate Coupon Maturity Time to Maturity Bid Price Yield to Maturity U.S. Tsy Yield Spread

10.950% Nov. 99 1.03yr. 94.50 16.99% 4.03% 12.96

9.250 Feb. 01 2.34 96.00 11.23 4.08 7.15

8.375 Dec. 03 5.16 93.00 10.14 4.21 5.16

11.000 Oct. 06 7.97 96.50 11.69 4.51 7.97

Time to Expiration Sell Default Protection Buy Default Protection

3 years 9.00% 10.00%

5 8.00 9.00

10 7.50 8.00

Synthetic structure

Pdf - Pd = long put (long CDS)

Example: Buying December 03 bond and buying protection produces return of (10.14 minus 9%). This return is 3.07 percent less than the return in a default free Treasury bond yielding 4.21%.

Sell February 01 and buy the U.S. treasury yielding 4.08 percent and selling 3-year default swap for 9 percent. This scenario produces total return from the synthetic long bond of 13.08 percent (4.08 percent plus 9 percent for selling CDS) as compared to the cash market yield of 11.23 percent picking up 185 basis points more in the synthetic structure.

Pd = Pdf - long put -long put = short put Investors can write default swap (sell protection), by posting

required margin and simultaneously buying risk-free instrument Pdf. The synthetic risky asset created usually has a higher yield than the yield on the cash market instrument.

Credit Default Swap Applications

Banks with credit exposure to corporate or sovereign bonds can be able to mitigate their risk through: Purchasing credit default protection Sell the loan in the secondary market

Banks who are willing to reduce concentration risk Sell default protection Buy a bond issued by an obligor to which they wish to have

exposure Lend money to an obligor to which they wish to have an

exposure Buy Credit-linked notes

Buyers of the default protections are:  Commercial Banks Non-financial corporations  Actively managed debt funds  Hedge fundsSellers of default protections are: Life insurance companies Reinsurance companies Major banks Collateralized debt obligations Commercial paper conduits

Recovery Rate

Credit Linked Notes

$1.1 billion 5-year Loan Five-year CLNs $1.1 billion proceeds Return of P&I Initial Loan

Citigroup

Trust

Enron

Investors

Fully Funded Securitization

Senior Notes

Loans proceeds 100 % Proceeds Sub-Notes

Proceeds

Bank SPV

Senior Notes

Subordinated Notes

Investors

Other Banks

A bank through CLO transaction can reduce its liabilities; improve on its higher rated lower yielding assets thereby increasing return on assets and return on equity.

Reduce concentration risk: CLO enables a bank to transfer its credit exposure to a particular borrower and a particular industry to the capital market fairly efficiently. The bank in the process of securitization assumes other credit risk to which it wishes to have greater exposure.

A bank can be able to manage its liquidity, credit spread, and concentration of assets tied to floating rate index such as LIBOR through its CLO transaction thereby improving asset/liability management.

Preserving bank-clientele relationship as the CLO enables the bank to sell its loan without damaging relationship with its customer, since the sponsor and the portfolio manager of the SPV trust is the affiliate of the bank and there is no need to notify the client in selling or assigning of the loans as is the case in selling loan in a whole loan basis.

Benefits of the structuring CLO

Synthetic CLO

Synthetic CLO emulates the cash CLO by transferring credit risk of the reference assets to the capital market through credit derivatives such as total return swap, credit default swap, or through issuing credit-linked notes without actually transferring the ownership of the assets to the bankruptcy-remote SPV trust.

Regulatory Capital relief Risk transfer Arbitrage profit Restructuring balance sheet

Motivations for structuring synthetic CLO/CBO

Synthetic Partially Funded CLO

Premium J.P. Morgan proceeds D

Bank loan Portfolio Senior

Tranche

Subordinated Tranche

SPV Trust Senior Notes Bankruptcy- remote assets Sub-Notes

Investors

Bank

Default protection

Premium

Default protection on sub-tranche

Proceeds

Sub-Notes

There are two, arbitrage and balance sheet. The arbitrage CLO, usually undertaken by

insurance companies, asset management, and investment banking firms to exploits yield miss-match (spread) on the underlying pool of assets and the lower cost of servicing CLO liabilities.

The balance sheet CLOs are employed by banks to mitigate and manage regulatory and risk-based capital.

Types of Synthetic CLO

The cash CLO on corporate exposure is 100 percent risk-weighted, while for synthetic CLOs, the risk-weighting is much less, reflecting the funded portion of the structure that is backed by government securities that is zero risk-weighted.

The above phenomena has prompted European banks to issue synthetic CLO by taking advantage of the fact that capital adequacy requirements (8 percent minimum capital on corporate exposure) do not differentiate between various levels of operating, market and credit risks.

Risk Weighting

BIS Capital Adequacy Requirement Original Exposure Method

Conversion Factor Maturity Interest Rate Swaps Foreign Exchange Swaps Less than 1 year .5% 2.0% One year & less than two years

1% 5%

For each additional year 1% 3% Capital requirements = Notional value of swap x conversion factor x risk weight Examples of capital requirements:

A. Five year Interest rate swaps, $200 million notional principal, counterparty OECD Bank. 200,000,000 x .05 x .20= $2,000,000

B. Three- year interest rate swaps; $20 million notional principal, counterparty AAA rated manufacturing firm.

20,000,000 x .03 x .50 = $300,000 C. Three year currency swap $100 million notional principal, counterparty GM. 100,000,000 x .08 x .50= $5,000,000

Source: Basle Committee on Bank Supervision, Treatment of Potential Exposure for Off-balance Sheet

Items (Basle, Switzerland, BIS, April, 1995).

The BIS capital requirements for various classes of debts for on-balance sheet requirements are as follows:

The sovereign government debt of the member of Organization of

Economic Cooperation and Development (OECD) is assigned zero BIS risk weight, these debts are treated as risk free and banks are not required to hold any reserve capital against them.

The senior debts of the banks from OECD are assigned 20 percent BIS risk weight; the banks are required to hold 1.6 percent (.20 x.08) of reserve capital for this type of debts. For example, a bank has to hold $320,000 in reserve capital (.20 x .08 x $200,000,000) for $200 million investment in a Mexican bank note.

Unfunded corporate revolving credits is assigned a 50 percent risk weight, the bank is required to hold a 4 percent (.50 x .08) reserve capital.

For all others, including corporate debts, funded revolving credit, non-OECD sovereign debts 100 percent BIS risk weight is assigned, requiring financial institutions to hold 8 percent reserve capital against the risk based assets.

BIS capital requirements

BIS Capital Adequacy Requirement Current Exposure Method

Add-on Factor for Maturity Interest Rate Swaps Foreign exchange rate

swaps Less than one year 0% 1% One to five years .5% 5% Five years or more 1.5% 7.5% Capital requirement: Credit Exposure x Risk-weight Example

1. Three year, $25 million interest rate swap, counter party is Microsoft, assuming swap is in the money by $360,000.00 Current exposure = Max (360,000,0)= $360,000 Potential exposure= $25,000,000 x .005= $125,000 Capital requirement= (360,000 + 125,000) x .50= $242,500

2. Five-year currency swaps $/ Euro $20million notional principal, assume swap is out of money by -300,00. Current exposure = max (-300,00,0) = 0 Potential exposure = 20,000,000 x .075 = $1,500,000 Capital requirement = (1,500,000+ 0) x .50 = $750,000 Source: Basle Committee on Bank Supervision, Treatment of Potential Exposure for Off-balance Sheet

Items (Basle, Switzerland, BIS, April, 1995).

Total Return Swap Payoff to the Receiver Assuming 5 to 10 percent Collateral

Posted by Hedge Fund on Notional Principal of $50 Million

Bond price Capital Gain Coupon Interest Interest Return Return in one year Loss Net on 5 % on 10 % realized Realized +225 bps Collateral* Collateral* 5 % 10 % Collateral Collateral 103 1,500,000 1,125,000 125,000 250,000 110 % 60 % 100 0 1,125,000 125,000 250,000 50 27.50 97 -1,500,000 1,125,000 125,000 250,000 -10 -2.5 95 -2,500,000 1,125,000 125,000 250,000 -50 -22.50 92 -4,000,000 1,125,000 125,000 250,000 -110 -52.50

*Assuming 5 percent interest is earned.

Motivations of the Receiver of TRS

The receiver is likely to have a host of reasons to enter into this HLT, for example:

Financing huge transaction with limited capital Exploiting the leverage as the return/risk can be

magnified Arbitrage profit albeit risky Access to capital market not previously available Sectoral arbitrage of credit risk in the high yield market

Leverage Impact on Return on Regulatory Capital

100 % BIS 20 % BIS Notional $30 million $30 million Reserve .08 .08 Risk weight 100% 20 % Capital Required .08 x 100% x $30 M .08 x 20% x $30 M Spread earned 55 bps 55 bps Income $165,000 $165,000 Return on Capital 6.875% 34.375 %