l9 Credit Derivatives 2011

Copyright SDA Bocconi, protocollo xxxx

Lecture 9: Credit Derivatives

Derivatives in Corporate Finance

Alonso Peña

SDA Bocconi, Intermediazione Finanziaria e Assicurazioni

Copyright SDA Bocconi, protocollo xxxx 2 2

Part 1: Introduction Part 2: Credit Derivatives: a Guided Tour Part 3: CDS Part 4: Examples

Contents


Part 1: Introduction


Hammurabi Code (1792 to 1750 BC)

First regulations of

interest, forgiveness of debt and extension of

credit

Payments through a local banker or by

written draft against deposit


Interest was rarely charged on advances by the temple or wealthy landowners for pressing needs. Merchants (and even temples, in some cases) made ordinary business loans, charging from 20 percent, for loans on silver, and 33.3 percent, for loans on grain.


Hammurabi's code also stated: “If any one owes a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for this year.”


Hammurabi's code also stated: “If any one fails to meet a claim for debt, and sell himself, his wife, his son, and daughter for money or gives them away to forced labor: they shall work for three years in the house of the man who bought them and in the fourth year they shall be set free.”


Credit, noun, the facility of being able to obtain goods or services before payment, based on the trust that payment will be made in the future. From the latin creditum, from credere, to believe.

Oxford English Dictionary (2007)

Introduction The word “credit”


Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both)

Introduction Credit Risk


Credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.

Introduction Credit Derivatives


A

B

INTEREST RATE derivative

client bank

Interest rate

A

B

CREDIT derivative

client bank

Credit


Introduction Types of Credit Derivatives


Credit default swap (CDS) Total return swap (TRS) Constant maturity credit default swap (CMCDS) First to Default Credit Default Swap (F2D) Credit Spread Option (CSO) CDS index products (iTraxx, CDX) Credit linked note (CLN) Collateralized Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO) Constant Proportion Portfolio Insurance (CPPI)

Introduction Types of Credit Derivatives


Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. The parties will select which credit events apply to a transaction and these usually consist of one or more of the following: • bankruptcy • failure to pay • repudiation • moratorium • restructuring

Introduction Credit Events


Introduction Market Size

Source: ISDA, Trillion USD


Introduction The most popular credit derivative…

credit default swap (CDS)

debt linked sensitive to default

exchange cashflows


Introduction Credit Default Swap


Part 2: A Guided Tour


Structural Models

Intensity Models

Guided Tour

credit risk

modeling

Credit Scoring Models


Credit Scoring Models


Structural Models


Merton, Robert C., "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates", Journal of Finance, Vol. 29, No. 2, (May 1974), pp. 449-470.

Merton (1974) Structural Model

t t tdV V dt V dW

evolution of the firm

growth component

random component


Merton (1974) Structural Model


Intensity Models


Robert A. Jarrow and Stuart Turnbull, "Pricing Derivatives on Financial Securities Subject to Credit Risk" Journal of Finance, vol. 50, March, 1995

Jarrow-Turnbull (1995) Intensity Models

survival probability

hazard rate (flat)

maturity

(0, ) expP T T



0(0, ) exp ( )

T

P T s ds

survival probability

hazard rate (term-structure)

Robert A. Jarrow and Stuart Turnbull, "Pricing Derivatives on Financial Securities Subject to Credit Risk" Journal of Finance, vol. 50, March, 1995

Copyright SDA Bocconi, protocollo xxxx 37

1%

5%

10%



Part 3: CDS


A

B client bank

Premium Leg

Default Leg

Credit Default Swap


A

B client bank

C

Premium Leg

Default Leg

reference entity (bond)

Credit Default Swap


A

B client bank

C


Premium Leg

Default Leg

Credit Default Swap


C


NO DEFAULT

DEFAULT

Credit Default Swap


A

B

bank

client

time

pa

y

NO DEFAULT Credit Default Swap

Premium Leg

Default Leg


A

B

bank

client

time

pa

y

Premium Leg

Default Leg

DEFAULT Credit Default Swap

Default


Part 4: Examples

l9 Credit Derivatives 2011

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