final credit derivatives
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8/6/2019 Final Credit Derivatives
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Credit Derivatives
Avinash Deshmane
Sachin Ghume
Nikunj Parekh
Mukesh
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Credit Derivatives
Credit Derivatives
Credit derivatives are over-the-counter bi-lateralagreements designed explicitly to shift credit risk
between the parties; its value is derived from the credit
performance of one or more corporation, sovereignentity, or security.
Credit derivatives arose in response to demand byfinancial institutions, mainly banks, for a means ofhedging and diversifying credit risks similar to those
already used for interest rate and currency risks.
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Credit Derivatives
Types of Credit Derivatives
Credit Default Swap
Total Rate of Return Swaps
Credit Spread Option
Credit Linked Note
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Credit Derivatives
Credit Default Swap
Credit default swaps allow one party to "buy"protection from another party for losses that might be
incurred as a result of default by a specified reference
credit (or credits).
The "buyer" of protection pays a premium for theprotection, and the "seller" of protection agrees to make
a payment to compensate the buyer for losses incurredupon the occurrence of any one of several specified
"credit events."
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Credit Derivatives
Credit Default Swap
Example:
Suppose Bank A buys a bond which issued by a SteelCompany.
To hedge the default of Steel Company:
Bank A buys a credit default swap from Insurance
Company C.
Bank A pays a fixed periodic payments to C, inexchange for default protection.
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Credit Derivatives
Credit Default Structure
Bank (A) pays a premium (single or periodic payments) to
a Insurance Company (B), but if a credit event occurs the
seller (B) will compensate the buyer.
DefaultProtection
BUYER (A)
Default
Protection
SELLER (B)
Reference
Entity
Contingent Payment if a
Credit Event Occurs
Fixed Payments / Premium
Credit
Exposureto Reference
Entity
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Credit Derivatives
Settlement Following a Credit Event Physical Settlement:
Protection BUYER delivers eligible debt (typically a bond orloan) to the Protection SELLER in exchange for a cash
payment equal to par
Cash Settlement: Calculation Agent makes a market value determination of loss
(par minus recovery) that the Protection SELLER is then
obligated to pay to the BUYER
Lump-sum
Fixed payment if a trigger event occurs
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Credit Derivatives
Example
T
he protection buyer (A) enters a 1-year creditdefault swap on a notional of $100M worth of 10-year
bond issued by XYZ. Annual payment is 500 bp.
At the beginning of the year A pays $500,000 to theseller.
Assume there is a default of XYZ bond by the end
of the year. Now the bond is traded at 40 cents on
dollar.
The protection seller will compensate A by $60M.
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Credit Derivatives
CDS Applications Delphi
Corporation Case Study
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Credit Derivatives
CDS Applications - DPH Trade
Solution Details
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Credit Derivatives
CDS Applications Delphi
Bankruptcy
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Credit Derivatives
Total Return Swap
Total return swaps are contracts between two
counterparties, under which the total economic risk of
ownership of a designated asset or set of assets is
transferred from one counterparty to the other. By the totaleconomic risk, we mean not just the credit risk of a
particular asset, but also the interest rate risk, and any other
more complex risks that may also impact the value of the
designated asset or set of assets.
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Credit Derivatives
The easiest way to understand how a total return swap works is by considering an
example:
Total Return Receiver : Counterparty A
Total Return Payer: Counterparty B
Start Date:10 December 1999
End Date:10 December 2004
Term:5 Years
Reference Asset XYZ Corporation Bonds
( 8% Coupon, Maturing 22 November 2019)
Initial Price of Reference Asset 102%Final Price of Reference Asset The price of the Reference Asset two business
days before the End Date
Nominal Amount: $10,000,000
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Credit Derivatives
Amount: Nominal Amount x Initial Price of Reference Asset
6 Month LIBOR + Floating Rate Margin, calculated on the
Notional Principal Amount,
Payable semi-annually for the term of the contract.
0.15%
Semi-annually in arrears, starting six months after the Start
Date.
The Total Return Receiver pays the Floating Rate Payment
to the Total Return Payer on each Floating Rate Payment
Date, until ( and including ) the End Date.
All coupons and other fees and cash sums payable to holders
of the Reference Asset.
Two business days after the Total Return Payments are
Received by theT
otal Return Payer from the Paying Agentof the Reference Asset.
The Total Return Payer pays the Total Return Payments to
the Total Return Receiver on the Total Return Payment
Dates.
Notional Principal
Floating Rate Payments:
Floating Rate Margin:
Floating Rate Payment Dates:
Floating Rate Payments:
Total Return Payments:
Total Return Payment Dates:
Total Return Payments:
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Credit Derivatives
EXAMPLE BASED ON ABOVE TERMS
To understand how this transaction works, imagine that Counterparty B, the TotalReturn Payer, has bought $10,000,000 nominal of the XYZ Corporation 8% bonds of
2019 in December 1999. What are the Counterparty B's cash flows, if he then also
enters into this total return swap?
From the bond, Counterparty B will receive coupons, so long as XYZ Corporation
doesn't default. Under the terms of the total return swap, however, Counterparty B
will not keep these payments, but will immediately pay them to Counterparty A asTotal Return Payments. In return, Counterparty A will pay the Floating Rate
Payments to Counterparty B; these are LIBOR plus a spread, calculated on the
amount that Counterparty B has invested in the XYZ Corporation bonds. So, overall,
Counterparty B is receiving a sequence of floating rate payments
( LIBOR + 0.85% ), and that's it, at least until 2004.
That is, Counterparty B has created the same effect as entering into an asset swap.The interesting thing is what happens when the total return swap ends: if the price of
the underlying bonds has increased over the term of the swap, Counterparty B pays
the profit to Counterparty A; if the bonds have fallen in price, however, Counterparty
A will compensate Counterparty B for the losses that B would otherwise incur.
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Credit Derivatives
Credit Spread Option
In finance, a credit spread, or net credit spread,
involves a purchase of one option and a sale of
another option in the same class and expiration but
different strike prices. Investors receive a netcredit for entering the position, and want the
spreads to narrow or expire for profit. In contrast,
an investor would have to pay to enter a debit
spread.
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Credit Derivatives
Consider the following scenarios:
The stock falls or remains BELOW $36 by expiration. In this case all the options expire worthless and the
trader keeps the net credit of $350 minus commissions (probably about $20 on this transaction)netting approx $330 profit.
If the stock rises above $37 by expiration, you must unwind the position by buying the 36 calls BACK,
and selling the 37 calls you bought; this difference will be $1, the difference in strike prices. For all
ten calls this costs you $1000; when you subtract the $350 credit, this gives you a MAXIMUM Loss
of $650.
If the final price was between 36 and 37 your losses would be less or your gains would be less. The
"breakeven" stock price would be $36.35: the lower strike price plus the credit for the money you
received up front.
Traders often using charting software and technical analysis to find stocks that are OVERBOUGHT (have
run up in price and are likely to sell off a bit, or stagnate) as candidates for bearish call spreads.
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Credit Derivatives
If the trader is BULLISH, you set up a bullish credit spread using puts. Look at the
following example.
Trader Joe expects XYZ to rally sharply from its current price of $20 a share.
Write 10 January 19 puts at $0.75 $750
Buy 10 January 18 puts at $.40 ($400)
net credit $350
Consider the following scenarios:
If the stock price stays the same or rises sharply, both puts expire worthless and you keep
your $350, minus commissions of about $20 or so.
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Credit Derivatives
If the stock price instead, falls to below 18 say, to $15, you must unwind the
position by buying back the $19 puts at $4 and selling back the 18 puts at $3
for a $1 difference, costing you $1000. Minus the $350 credit, your maximumloss is $650.
A final stock price between $18 and $19 would provide you with a smaller loss or
smaller gain; the breakeven stock price is $18.65, which is the higher strike
price minus the credit.
Traders often scan price charts and use technical analysis to find stocks that are
OVERSOLD (have fallen sharply in price and perhaps due for a rebound) as
candidates for bullish put spreads.
NOTICE IN BOTH cases the losses and gains are strictly limited. This is a nice
strategy for earning a modest amount of income from a portfolio that can be
used to supplement your wages, dividends, or social security payments as long
as you're aware of the limits
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Credit Derivatives
Credit Linked Notes (CLN)
CLNs are generally created through a Special Purpose Vehicle(SPV), or trust, which is collateralized with highly rated
securities. CLNs can also be issued directly by a bank or
financial institution.
A CLN is normally a bond that has been issued using a mediumterm note programme.
It is the direct obligation of the issuer but it contains additional
credit risks for the buyer.
The principal repayment is linked, not only to creditworthiness ofthe issuer but also a third party known as the reference entity.
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Credit Derivatives
Credit Linked Notes (CLN)
Provided the reference entity experiences no credit event during thelife of the CLN the principal will be repaid to the investor on
maturity.
During the life of the note the investor will also have received
regular interest payments (coupons).If the referenced entity defaults or declares bankruptcy, in which
case, instead of receiving the principal amount originally
invested, the investor receives a bond issued by the reference
entity. The investor will have experienced a loss as a result of the
credit event because the delivered bond will be worth less than
the original sum invested. The scale of the loss incurred will
depend on the market value of the delivered bond
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Credit Derivatives
Example
Start with the CLN issuer or Bank,
who owns a bond. Instead of
shouldering the risk of the bond,
Bank issues a note to the CLN
buyer. The note has an embedded
credit feature. It pays a highercoupon unless the bond is
downgraded or defaults. If the bond
is downgraded, the coupon paid by
the CLN issuer to the CLN buyer is
reduced. If the bond defaults, theCLN issuer diverts recovery (i.e.,
par value minus expected recovery
rate) to the CLN buyer.
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Credit Derivatives
Synthetic CLN
In this case, the CLN issuer or Bank does not
own the bond (the risky asset). Instead, the CLNissuer achieves synthetic exposure to the bond by
selling a credit default swap (CDS) to the bond's
actual owner. Selling protection would mean the
Issuer received a regular fixed payment from the
CDS counterparty.
The bank now issues the CLN. The CLN would
be for the same principal amount and maturity as
the CDS. The Bank sells a note to the CLN
buyer, but the proceeds are invested in a riskless
asset. The CLN buyer would pay cash to the CLN
Issuer to buy the note. The Issuer would pay the
buyer regular interest (coupons) until thematurity of the note.
Provided there is no credit event by the reference
entity the buyer receives back the principal
investment on the maturity of the note.
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Credit Derivatives
Synthetic CLN
If there is a credit event, The CDS on which the
Issuer sold protection is triggered. The bank paysto the CDS counterparty the principal amount of
the CDS in cash. The bank receives in return a
deliverable instrument normally a bond that was
issued by the reference entity that is now in
default.
The CLN is also triggered. The investor does not
get his principal returned, instead the bank on-
delivers the bond to the CLN buyer. The investor
will have experienced a loss as a result of the
credit event because the delivered bond will be
worth less than the original sum invested. The
scale of the loss incurred will depend on themarket value of the delivered bond.
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Credit Derivatives
Thank You
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