Sg credit derivatives overview

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Introduction to Credit Derivatives

Introduction to Credit Derivatives01


Credit Risk and Credit Derivatives

Market for Credit Derivatives

Credit Derivative Products

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Credit risk is the risk of a financial loss due to a reduction in credit quality of a borrower/debtor/obligator.

Default risk is the risk that an borrower/obligator does not repay part or his entire financial obligation.

o If default occurs, the creditor will only receive the amount recovered from the debtor called recovery value.

Credit deterioration risk is the risk that the credit quality of the borrower/debtor might decrease.

Default risk can be viewed as a subcategory of credit deterioration risk since default occurs for large credit deterioration

Credit Risk

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Credit derivatives are financial instruments designed to transfer credit risk from one counterparty to another

Credit derivatives allow an investor to reduce or eliminate credit risk or to assume it expecting to profit from it.

Credit derivatives are financial instruments whose value is derived from the credit quality of an underlying obligation which is usually a bond or a loan.

Credit Derivatives

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o Bankruptcy It is widely drafted so as to be triggered by a variety of events

associated with bankruptcy or insolvency proceedings o Failure to Pay

Failure to Pay is defined to be a failure of the reference entity to make, when and where due, any payments under one or more obligations.

o Restructuring Restructuring covers events as a result of which the terms, as

agreed by the reference entity or governmental authority and the holders of the relevant obligation, governing the relevant obligation have become less favorable to the holders that they would otherwise have been.

Other events

Credit Events

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The Market for Credit Derivatives

The global growth of credit derivative trading volumes has increased to about 2 Trillion dollars.

Still a relatively small portion of the USD 61.4 trillion OTC derivatives market.

The credit derivatives industry is expected to be worth over US$7 trillion notional outstanding by 2006.

Uses:

•Allow lenders to diversify their portfolios of loans and other risky assets.

•Used to reduce credit risk exposure.

•Exploit arbitrage opportunities.

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Market Participants

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Credit Default Swap (CDS) Total Rate of Return Swap (TRS) Collateralized Debt Obligation (CDO)

Credit Derivatives Products

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Credit Derivative Products:Credit Default Swaps

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Definition/terminology

Features of default swaps

What constitutes default

Risks covered

Hedging with default swaps

Types of CDs

Key benefits of CDs

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Credit Default Swaps (CDS)

Transfers credit risk inherent in bonds/ loans/other credit instruments to counter-party

Owner of risky asset is “protection buyer” Counter-party willing to take up risk is “protection seller” Protection buyer pays seller a premium at specified intervals

(eg. LIBOR+10 bp every 6 months)

Default Swap Buyer

Default Swap Seller

Premium (upfront or periodically)

Payment in case of default of a reference obligation

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Upon occurrence of a Credit Event, protection seller pays the buyer the amount of the loss.o Cash settlement – seller pays buyer difference between par

amount and current asset value

o Physical settlement – buyer hands over impaired asset to seller and gets par value in return

The default swap premium is often called the default swap spread

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Key parameters in CDS Transactiono Defining the default event

o Determination of Premium or Default Protection Fee

o The reference Obligation, its notional amount

o Maturity of the swap

o Determination of Reference Asset, its notional amount

o Determination of default payment

o Type of settlement• Physical

• Cash

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Motivation of Protection Buyero Risk reduction

o Reducing Regulatory Capital

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Motivation of Protection Sellero Access to new assets

o Extreme leverage advantage

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Applications of Credit Derivatives

Regulatory Capital Reliefo Large commercial banks account for the most common application of

credit default options: reducing regulatory capital.

o Regulatory capital is the percentage of equity capital that a bank must maintain in relation to its assets (e.g. loans), typically 8%.

o Equity is relatively expensive to fund.

o With the protection afforded by an instrument such as the credit default option, only 20% of the recommended 8% holding is required.

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Applications: Buying Bonds Synthetically

Buying Bonds Synthetically o Some institutional investors sell credit default options in order to

assume the risk and return of a bond without owning the asset outright, an application known as buying the bond "synthetically.“

o Investor sells a credit default swap on $1 million face of 5-year BBB-rated bonds.

o The investor assumes the risk of default, similar to the risk assumed by the actual bondholder, and receives payments in return, also similar to those received by the bondholder.

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Application: Diversifying Loan Portfolios

If a bank's loan portfolio is over-concentrated in a given industry, credit default options can help diversify the portfolio without sacrificing existing loan relationships.

Texas bank is heavily exposed to the energy sector during a period of oil price volatility

The bank would like to diversify its portfolio solution is for the bank to buy default options on the oil loans and sell

default options on loans with a low correlation to the energy sector

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Basket Default Options

Basket Default Optionso The buyer of a basket default option exchanges a premium for default

protection on a group of equally rated bonds or loans, most commonly on a "first-to-default" basis.

o If one asset in the basket defaults, the buyer receives a loss payment and the option terminates

o This allows the investor to protect several different assets for typically less than the price of protecting each asset individually.

o Variations on the first-to-default structure include the "nth-to-default" option and the "portfolio default swap."

o High asset correlation lowers the likelihood of a default payment since the conditions under which default may occur are restricted to roughly a single asset.

o Low asset correlation increases the likelihood of default payment since these conditions widen to include several different assets.

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Credit Derivative Products:Total Rate of Return Swaps(TRORs)

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Definition/Terminology

Difference between TROR and CDS

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Total Rate of return Swaps (TRORs/TRS)

Exchange total economic performance of a specified asset for another cash flow.

Total return includes all interest, fees and change-in-value payments. Payments for changes in value may be made, at maturity or

periodically. May involve physical delivery on maturity instead of cash settlement. Maturity of TRS typically less than maturity of underlying.

TRS Payer

Reference Asset

owns

Total return of asset TRS ReceiverLIBOR +Y

(Bond, Loan, Index, Equity, Commodity)

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Total Rate of return Swaps (TRORs/TRS)Effect of events

Rating downgrade -> leads to drop in value of asset -> this drop is made good by receiver to payer

Rating upgrade -> leads to rise in value of asset -> this rise is transferred by payer to receiver

Asset defaults -> asset holder faces loss -> this loss made good by receiver

TRS compared to CDS CDS transfers only Credit risk, TRS transfers both Credit and Price risk.

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Total Rate of return Swaps (TRS) – Motivation of Receiver

Create new assets with custom maturities Access to asset class not normally available Exposure to underlying without upfront acquisition cost- Extreme

leverage advantage Off-balance sheet exposure to desired asset class Off-balance sheet exposure leading to higher ROA Fill credit gaps in portfolio or access entire asset class by receiving

total returns on an Index

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Total Rate of return Swaps (TRS) – Motivation of Payer

Eliminates credit risk and price risk Investors who cannot short securities can hedge a long position Banks might achieve regulatory norms on total asset risk Allows short term negative view on an asset without sale Defer loss/gain without risking further loss

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Comparison of CDS and TRS

Both allow for transfer of default risk Price Risk

o TRS also transfers price risk – any drop in price of asset is transferred to return receiver in TRS – whereas CDS is activated only on credit event

o Entity seeking to hedge both price and default risk uses TRS

o Entity seeking to hedge only default risk uses CDS Underlying asset

o TRS can be used for any underlying asset class

o CDS can be used only for instruments with default risk (fixed income instruments)

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Credit Derivative Products:Credit Spread Products

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Credit Spread Options

Credit Spread Forwards

Credit Spread Swaps

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Credit Spread Options

Right to receive a cash payment if a spread widens beyond an agreed strike level during a specific period

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Credit Spread Forwards

Commits the buyer to purchase the specified bond or loan at a specified future date at a price specified at contract origination

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Credit Spread Swaps

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Synthetic Structures:Synthetic Collateralized Debt Obligations (CDOs)

05Introduction to Credit Derivatives

01 Cash CDO

02 Synthetic CDO

03 Motivation for CDOs

04 CDO Squared Structures

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Collateralized Debt Obligation (CDO)

Asset Securitization A Bank owns some risky assets that it wants to sell. It creates a separate Special Purpose Vehicle (SPV) legal entity Offers to sell the assets to SPV in exchange for cash SPV offers to issue a note, or set of notes, to investors, promising to

collateralize the notes with the payments from the assets. Bank works with the rating agencies, lawyers, accountants, and

investors to define the collateral pool and the structure of the notes. The SPV sells the structured notes to the investors, and uses the cash

to buy the assets from the bank. Payments are made to the CDO Bond holders based on the cash flows

that come in from the underlying risky assets Bond Investors take on risk and return from the underlying assets Bank sold the assets, and got cashed out upon the sale of the bonds Bank uses the money to make new loans, and starts the process again

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Structure

Bank Special Purpose vehicle (SPV)

End Investor

Sells risky assets

Cash

CashIssues CDORisky Assets Sold

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The CDO notes/bonds that are offered to investors reflect various combinations of yields, maturities, credit quality, payment priorities, etc.

The individual notes offered to investors are called “tranches”, French for “slices”.

Some of the tranches are more senior, or junior, in terms of their priority of receiving cash flows.

The tranches are structured to appeal to different investors with different risk and return appetites.

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Synthetic CDO

In the previous structure, where the bank who owns the assets and sells them to the Special Purpose Vehicle, we call that a Cash CDO.

Banks also use Credit Default Swaps, whereby a credit default swap, reflecting the risk premium associated with the risk of the risky pool of assets, is combined with an investment in riskless assets, say US Treasuries, and the two sets of assets combine to provide the cash flow to the CDO investors.

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CDO Squared

Notes or Bonds that are themselves CDO’s can be used as loans which are then pooled with other CDO tranches, to create a new tranche in a new offering.

Doing so creates a CDO of a CDO, This is called a CDO Squared. And this process can be repeated, over and over.

Sg credit derivatives overview

Economy & Finance

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