d86feModule 6

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Credit Default Swap


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Credit derivatives

Single Name Instruments and Strategies Credit Default Swaps

Credit Curves

Options on CDS

Basis (Cash vs. Derivatives)

Portfolio Instruments and Strategies Credit Indices

Options on Indices


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What is a SWAP?

Swap is a derivative in which two counterpartiesagree to exchange a sequence of cash flowsover a period in the future.

Swaps are usually used to hedge risks (ex.interest rate risk), or to speculate on changes inthe underlying prices.

Swaps can be interest rate swaps, currencyswaps, commodity swaps, equity swaps, and

credit default swaps.


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Credit Default Swaps

A Credit Default Swap (CDS) is similar toan insurance contract, providing the buyer

with protection against specific risksassociated with defaults, bankruptcy orcredit rating downgrades.


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Characteristics

CDS is the most widely traded creditderivative product. Typical term of CDScontract is 5 years (up to 10-year CDS).

CDS documentation is governed by theInternational Swaps and Derivatives

Association (ISDA), which providesstandardized definitions of credit defaultswap terms, including definitions of whatconstitutes a credit event.


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Mechanism

One party sells risk and the counterpartybuys that risk.

The seller of credit risk - who also tendsto own the underlying credit asset - pays a

periodic fee to the risk buyer.

In return, the risk buyer agrees to pay the

seller a set amount if there is a default.


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Transaction Diagram

Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001

Risk seller orRisk Buyer or


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Potential Benefits

In addition, to hedging event risk, the CDSprovides the following benefits:

A short positioning vehicle that does not require an

initial cash outlay. Access to maturity exposures not available in the

cash market.

Access to credit risk not available in the cash market

due to a limited supply of the underlying bonds. Investments in foreign credits without currency risk.

Ability to effectively exit credit positions in periodsof low liquidity.


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Quoting CDS

5 year CDS for Ford Motor Company debt

Nominal amount = $10 million

160 bp on April 27, 2004 5-year protection

How much will you pay for protection? (0.0160 / 4) x 10,000,000 = $40,000 (everyquarter as a premium for protection againstcompany default)


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1-year CDS Contract

Investor

Loan

Borrower

Bank

Premium payments

Loss recovery

Credit

($10 mln)

High-riskentity for default

No default: Zero


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1-year CDS Contract

Nominal amount = N

Premium = c

Quarterly payment = Nc/4

There are 5 possible outcomes in this CDS contract: No default (4 premium payments are made by bank to

investor until the maturity date)

Default occurs on t1, t2, t3, or t4

t=0 t=2 t=4t=3t=1

Effective date


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Summary

Due to its protection nature CDS marketrepresents over one-half of the globalcredit derivative market.

CDS allows a party who buys protection totrade and manage credit risks in much thesame way as market risks.


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Energy Derivatives


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Introduction

Common Derivative Structures

Common Energy Products

Common Risk Management Strategies


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Common Energy DerivativesPhysical vs. Financial Contracts

Physical transaction

A contract in which the actual (physical)commodity is transferred between parties to the

contract. (i.e., Party A sells and delivers gas toParty B)

Financial transaction

A contract in which no commodity is transferredbetween parties and parties only exchange cashpayments in amount equal to the financialbenefit of holding the contract (i.e., Party A pays

Party B the change in the contract value fromince tion to ex iration


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Common Energy Derivatives Futures

Exchange traded

Essentially financial

Forwards

Over the counter (OTC) Physicals

Swaps

OTC

Financials Options

Exchange traded or OTC

Physical or financial


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Common Energy Markets

New York Mercantile Exchange (NYMEX)

Intercontinental Exchange

Independent System Operator (ISO) Over-the-Counter

Broker


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Common Energy DerivativesExchange Traded Futures and Options

A legal agreement between a buyer or seller and theclearinghouse of a futures exchange

Futures contracts generally have the followingcharacteristics:

They obligate the purchaser (seller) to accept (make)delivery of a standardized quantity of a commodity orfinancial instrument at a specified date or during aspecified period, or they provide for cash settlementrather than delivery

They are defined by standard delivery points andvolumes

They effectively can be canceled before the deliverydate by entering into an offsetting contract

All changes in value of open contracts are settled on aregular basis, usually daily.

They carry no credit risk


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Common Energy DerivativesExchange Traded Futures and Options

New York Mercantile Exchange (NYMEX) Natural Gas (NG) Futures Contract

Trading Unit: 10,000 million British thermal units (mmBtu). Trading Months: The current year and the next five years

Last Trading Day: Trading terminates three business daysprior to the first calendar day of the delivery month. Delivery: The Sabine Pipe Line Co. Henry Hub in Louisiana

Crude Option (LO) Trading Unit: Option: One NYMEX Division light sweet crude

oil futures contract. Future: 1,000 US barrels (12,000 gallons)

Trading Months: Crude oil options are listed seven yearsforward

Last Trading Day: Option trading ends three business daysbefore the underlying futures contract. Futures: Tradingterminates three business days prior to the 25th of the monthpreceding the delivery month

Delivery: West Texas Intermediate


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Common Energy Derivatives

OTC Forwards (Physicals) Symmetrical exposure Over-the-counter contract to purchase or sell a

specific quantity of a financial instrument, a

commodity or a foreign currency Pre-determined specified price

Settlement at a specified future date

Can be settled by actual delivery of the item inthe contract, or net cash settlement

Credit Risk

Exchange of Collateral, Letters of Credit, Parental

Guarantee


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OTC - ForwardsForward Sale of Power at $70

Utility Marketer

Delivers 100 MW

Pays $70/MW


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OTC - Swaps Over-the-counter contracts to exchange cashflows as of a series of specified dates (swap)

Based on agreed upon notional amount

Pre-agreed fixed rate; pre-agreed variable index

Symmetrical exposure

Credit Risk

Exchange of Collateral, Letters of Credit, ParentalGuarantee

Examples:

Fixed vs. Float Swap


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OTC - OptionsA financial instrument which represents a contract sold by

one party (option writer) to another party (option holder).

The contract offers the buyer the right, but not the obligation,to buy (call) or sell (put) a financial or physical asset at anagreed-upon price (strike price) during a certain period oftime or on a specific date (exercise date).

Option Premium: price the option holder pays for the right tobuy or sell the financial or physical at a specified price in the

futureAccounting for Premium is over the life of the option, not the

delivery period.


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Common Energy

Products/Contracts - Gas Natural Gas Transportation

Full Requirements contracts Trigger contracts

Park and loans

Storage contracts Take or pay contract


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ommon nergyProducts/Contracts - Power

Electricity

Capacity

Transmission & Distribution

Tolling agreements

Renewable Energy Credits


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Common Energy Derivativesand Their Use to Manage Risk

How are these Products/Contracts Used?

Lock-in prices

To fix the purchase or sales price of an

energy commodity at a future point intime

Protect against unfavorable price

movements Example:

Collar (put and call)

Swap


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Common Energy Derivatives and

Their Use to Manage Risk Option Collar - A Zero Cost Collar strategycombines the sale of a Call Option and thepurchase of a Put Option

The Option premium collected by the sale ofthe Call Option with a higher strike price(capped sale price) will fund the purchase of a

Put Option with a lower strike price (cappedpurchase price).


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Common Energy Derivatives and

Their Use to Manage Risk Reduce earning volatility Investors/Capital Markets may desire

predicable future earnings

May be achieved by locking-in both thepurchase and sales price of a product,regardless of future price movements

Manage other risks Basis risk (locational)

Credit risk

Operational risk (physical delivery, plantouta es


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W

eather Derivative


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History Heating Degree Day (HDD) weather derivatives first

introduced in 1997

The following factors contributed to the birth ofweather market that year:

Convergence of capital and insurance markets

Risk capital availability

Deregulation of the electricity markets that started in 1996

Enron prominence and strive for innovation

Easy availability of (reliable) meteorological data By 1997, environmental markets already existed (air

pollutants)


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Most common financial options

are: Futures (swaps)

Calls

Puts

( )V N P X !

_ amax ( ), 0V N P X !

_ amax ( ), 0V N X P !

whereV is payoffN is notional amountP is the actual value of settlement indexX is the strike

X P

V

X P

X P


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Comments

Examples of settlement indices: equity prices

commodity prices

FX rates

interest rates From the buyers perspective,

Swaps are:

risky (have both upside and downside potential)

costless Calls and puts:

risk free (no downside), but:

require up front premium


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Examples of weather indices

Temperature based Heating Degree Days (HDDs) Cooling Degree Days (CDDs)

NORDIX (NORmal Departure IndeX)

Max, min or average daily temperature

Precipitation Snow

Rain

Wind Speed along specified direction

Wind farm output

Variance


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Cooling and Heating DegreeDays (CDD/HDD)

Daily cooling (cdd) andheating (hdd) degreedays:

_ a_ a

,min ,max

max 65 , 0

max 65 , 0

where is defined as

2

o

i i

o

i i

i

i i

i

cdd t

hdd t

t

t tt

|

|

|

( )

1

( )

1

n M

M i

i

n M

M i

i

CDD cdd

HDD hdd

!

!

|

|

Monthly cooling (CDD)and heating (HDD)degree days:

N(M) is the number o days

in month M


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Applications

Hedging Agriculture

Ski resorts

Construction

Reinsurance Entertainment (theme parks, wine bars etc.)

Retail and wholesale

Energy

Speculation

Forecasting


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Risk management

Weat er R

P&

Pr

bab

t

ensit

Bad risk Good risk

Expected

Challenge of risk management: minimize the potentialdownside while retaining the upside


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Risk management

Weat erRisk

P&

Probabilit

d

ensit

Bad risk Good risk

Expected

Challenge of risk management: minimize the potentialdownside while retaining the upside

Theres no free lunch; never works this way


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Risk management

Weat erRisk

P&

Probabilit

d

ensit

Bad risk Good risk

Expected

Ultimate challenge of risk management: minimize thepotential downside while retaining the upside

Theres no free lunch; never works this way

Realistic risk management: minimize the downside at the

lowest possible cost (squeeze the distribution)


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Example: ski resort

Lets assume

P = $50 Historic analysis shows that resort sells ~1000 less tickets (per

season) per every inch of snow below normal

To hedge this exposure, the resort buys a put that pays

$50,000 x (normal snowfall - actual snowfall), or 0 if actual is

above normal

R N P ! v WhereR is revenueN is number of tickets soldP is ticket price


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Example: weather exposure ofpower (gas)retailer associated with Full Service

equirements contract


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100 MWh

T=$50/MWh

ElCo

ElCo sells Best Eastern a Full Service Requirement (FSR) contract todeliver power November through March at $50 perMWh

Under normal weather conditions, Best Easterns hourly energydemand is estimated to be 100 MWh

BestEastern


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100 MWh

T=$50/MWh PF=$48/MWh

100 MWh

ElCo


Under normal weather conditions, Best Eastern s hourly energydemand is estimated to be 100 MWh

To hedge its price exposure, ElCo buys power forward to be deliveredNovember through March at the flat hourly rate 100 MWh at $48 perMWh

BestEastern


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100 MWh


100 MWh

ElCo


Under normal weather conditions, Best Eastern s hourly energydemand is estimated to be 100 MWh

To hedge its price exposure, ElCo buys power forward to be deliveredNovember through March at the flat hourly rate 100 MWh at $48 perMWh

Expected net profit to ElCo = $724,800

= 100MWh x 151 days x 24 hrs x ($50-$48)

BestEastern


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Winter is colder than expected so the Best Easterns hourly powerdemand ends up being 115MWh


100 MWh

ElCo

115 MWh

BestEastern


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ElCo has to buy additional 15 MWh priced at $80/MWh on the spotmarket

115 MWh


100 MWh

ElCoBest

Eastern


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ElCo has to buy additional 15 MWh priced at $80/MWh on the spot

market

Net loss to ElCo = $906,000

= 151 days x 24 hrs x

[ 115 MWh x $50 100 MWh x $48 15MWh x $80]

115 MWh


100 MWh

ElCoBest

Eastern


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Conclusions

Weather derivatives market is growing Energy industry remains its largest client

Weather derivatives are gaining popularity in theinvestment community (diversification, independence

of market behavior) This raises the demand for high quality meteorological

and climatological data, forecasts and modeling, andtherefore has a potential to alter the economics of

atmospheric science (commodification of weather) Weather market indices can be used for forecasting

weather and climate

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