11-12 1st mfi credit derivatives

8/3/2019 11-12 1st MFI Credit Derivatives

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AF 4322MANAGEMENT

OFFINANCIAL INSTITUTIONS

Managing credit risk using credit derivatives& problems with the credit default swapsmarkets


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Learning Objectives

Credit risk transfer using credit derivatives.

The features of the following common creditderivatives: CDS, CLN, CDO and TRS.

How these credit derivatives are used eitherfor hedging or participating (speculating)credit risk.

The problems with the CDS markets.


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Readings

This Powerpoint notes.

Lee, A. & Law, E.(2003). Credit risk transferusing derivatives and implications forfinancial market functioning, HKMA ResearchMemorandum, December. (focus on p2-4only)

Fortune (2008). The $55 trillion question,October 13, p57-60.


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Credit Derivatives

Credit derivatives are a relatively newderivative offering payoffs based on changesin credit conditions along a variety ofdimensions. Almost nonexistent twenty years

ago, the notional amount of credit derivativestoday is in trillions of dollars.

We discuss the most popular credit

derivatives used in the market: credit defaultswaps, credit linked notes, syntheticcollateralized debt obligation and total returnswaps.


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Credit Risk Transfer Using Credit

Derivatives

Facilitates the transfer of credit risk withouttrading the underlying assets that give rise tocredit exposures.

Initiated by parties who may or may not ownthe underlying assets.

Allow either full or partial credit protectionunder specified circumstances for theprotection buyer.


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Definition of Credit event

Settlement of credit derivatives are usually initiatedby the occurrence of some pre-defined creditevents. Examples of credit events:

Failure or credit rating downgrading of the

reference entity / security / indexetc.

Bankruptcy

Obligation default

Restructuring

Repudiation/moratorium


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Credit Derivative Instruments

1. Credit default swaps (CDSs)

2. Credit linked notes (CLNs)

3. Synthetic collateralized debt obligations(CDOs)

4. Total return swap (TRS)


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Credit default swaps involve one party who wantsto hedge credit risk to pay a fixed payment (premium)on a regular basis, in return for a contingentpayment that is triggered by a credit event.

Counterparty agreement Allows the transfer of third party credit risk from one party

(protection buyer) to the other (protection seller)

Protection buyer pays premiums regularly in return

for credit risk protection and protection sellerreceives the regular premiums and takes up thecredit risk (similar to insurance business).


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It is unfunded in nature in that the protection sellerdoes not have to provide upfront funding at theinitiation of the CDS.

When a credit event happens, the CDS will besettled according to pre-determined arrangement.

Existence of counterparty risk of protection seller It is because CDS is unfunded in nature, protection buyer

faces the counterparty risk of the protection seller in that

the seller may not be able to meet the obligation to settlethe CDS when needed.


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Protection buyerProtection seller

Premium

Contingent payment in case

the specified credit eventoccurs


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Regular coupon paying note CLN is just a kind of coupon paying note with a higher yield

offered and issued by the protection buyer.

Funded in nature The protection seller of the CLN makes an upfront payment in

buying the CLN and in return receives periodic coupon paymentsand principal at maturity if no credit event occurs.

Physical or cash settlement When a credit event occurs, the protection seller is either

delivered the reference security which has defaulted (physical

settlement) or paid a net settlement amount equal to the marketprice of the asset, but in this case, the protection seller faces thecounterparty risk of the protection buyer..


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Issuer of CLN(protection buyer)

Investor(protection seller)

Principal + couponOn credit event

occurrence: cash /physical settlement lessunwind costs

CLN proceeds


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3. Synthetic collateralized debt

obligations (CDOs)

Reduced the counterparty credit risk of boththe protection buyer and seller by setting up aSPV that are at least partly backed by the

collateral securities. The SPV makes a CDS with the protection

buyer.

The SPV issues CDOs to the protection sellerand invests the proceeds in high-qualitybonds and asset-backed securities.


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obligations (CDOs)

The protection seller receive the return on thecollateral and the premium on the CDS theSPV sells to the protection buyer.

In case the credit event occurs, the paymentto the protection buyer will take priority overthat to the protection seller, thereby reducingthe principals and / or the interest payments

to the investors.


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obligations (CDOs)

High quality

securities

Protection buyer

SPV-

protection seller

Investors-

end-seller

CDO proceeds

Risk-free cashflowCDSpremium

CDSsettlement

CDO proceeds

Interest+principal


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4. Total Return Swap (TRS)

A bilateral financial contract designed to exchangecash flows related to the return of a reference asset. Protection buyer agrees to pay the protection seller

the total return of a defined underlying asset. In return, the protection buyer receives a stream of

LIBOR-based cash flows. TRS is importantly distinct from a CDS in that it

exchanges the total economic performance of aspecified asset for another cash flow irrespective of

whether a credit event has occurred.


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4. Total Return Swaps (TRS)

TR payer(Protection buyer)

TR receiver(Protection seller)

Returns from coupons and gainsdue to changes of market value

of the reference obligation

LIBOR + margin + losses dueto

changes of market value of thereference obligation


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Problems with the CDS Markets

Mainly OTC transactions between FIs whichwere mostly unregulated.

Instead of using CDS for managing credit risk,

many participants used CDS for speculativepurposes.

CDS became popular speculative toolsbecause of the easiness of entering into a

CDS agreement.


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CDS buyers are not required to own theunderlying default risky assets (naked CDS).

Usually no cash upfront requirement for theCDS sellers.

As a result, CDS markets became the worldslargest casino before the financial crisis.


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Counterparty risk of CDS seller exists for theCDS buyer but no idea of CDS sellers

exposure to CDS due to non-transparency ofCDS transactions.

The problem with AIG reflected that creditrisk was not diversified across different CDS

sellers.


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Similarly, many CDS sellers did not havesufficient capital to support their exposure toCDS and default of CDS sellers would inducea domino effect within the financial system.

US commercial banks believed that credit riskcould be transferred away through CDSwhich in turn encouraged their more

aggressive lending activities such as in sub-prime mortgages.

11-12 1st mfi credit derivatives

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