credit derivatives. a credit derivative financial instrument allows participants to decouple credit...

Credit Derivatives

Credit Derivatives

A credit derivative financial instrument

Allows participants to decouple credit risk from an asset and place it with another party

Credit Risk

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.

To reduce or strip out Credit risk, Risk Manager may :

• Take Collateral

• Make loss provisions

• Actively manage the Credit Risk Exposure

• or use Credit Derivatives : Credit Default Swaps (CDS)

Credit Risk

• Downgrade Risk

- Rating agency reduces debtor’s credit rating

- Reduces value of debt

• Default Risk

- Loan not repaid in full

- Future cash flows not certain

Rating Agencies•Risk is measured by rating agencies

- Moody’s

- S&P

- Fitch

•Rating scales:

Types of Credit Derivatives

•Credit Default Swap (almost 90% of all transactions)

•Dynamic Credit Default Swap

•Credit intermediation Swap

•Basket Credit Default Swap

•Total Rate of Return Swap

•Credit (spread) Option

•Downgrade Option

•Collateralized Instrument

•Credit-linked Note

•Synthetic Collateralized Debt Obligation

Credit Default Swaps CDS

First CDS

introduced in 1995 by JP Morgan

in an attempt to free up all that capital they were obliged, by federal law, to keep in reserve in case any of their loans went ‘bad’.

•Estimated Size of the CDS market (Q1 2008):

USD 65 trillion

Global GDP: USD 55 trillion (2007,IMF)

Characteristics of Credit Default Swaps

•Market of CDS is divided in three sectors:

Corporates

Bank credits

Emerging markets sovereign

•OTC agreement (privately negotiated transactions)

•CDS ranges in maturity from one to ten years

•Five year maturity is the most frequently traded

•CDS provides protection only against previously agreed upon credit events

Credit EventsAccording to ISDA 2003 Master Agreement

•Bankruptcy

(insolvency or inability to pay its debts)

•Failure to pay

(principal or interest)

•Debt Restructuring

(change in the terms of the debt that are adverse for creditors)

•Repayment Acceleration on Default

•Repudiation

(sovereign only – indication that a debt is no longer valid)

One of this event has to have happened on the reference entity in order a CDS payment to be made

What is a single CDS

•Bilateral contract

•Protection buyer pays premium to protection seller

•Protection seller contingent payment upon default of reference asset

•One party usually owns the Reference asset

Otherwise: transaction does not involve credit exposure speculation on behalf of both parties

•Premium paid is known CDS Spread

Reference Asset

•Bank loan

•Corporate debt

•Trade receivables

•Emerging market debt

•Convertible securities

•Credit exposures from other derivatives

CDS Spread

• Quoted in Basis Points per annum

• Paid periodically

If corporate quarterly

sovereign monthly

• Credit Spread =Default probability x (1-recovery rate)

• Premium = notional amount x CDS spread p.a.

Example on Premium of Bulgarian 5Y CDS

Notional amount = USD10,000,000

Spread= 494 b.p.

Premium = notional amount x CDS spread

= 10,000,000 x 0.0494

= 494,000 p.a.

Payoff from CDS

The payoff can be defined in terms of

•Physical delivery of the reference asset

delivery of the Defaulted Bond for the Par value (no later than 30 days after the credit event)

or

•Cash Settlement

pays the Protection Buyer the difference between the Par value and (real) Recovery value of the Bond (within 5 days of the credit event)

Settlement terms of a CDS are determined when the CDS contract is written

Buyers and sellers of protection

Cash Settlement ExamplePayoff from a Credit Default Swap

Bank A holds a corporate bond issued by C

Reference asset Bond C, maturing in two years


To reduce credit risk:

Bank A enters in two year CDS with Bank B, with notional amount 10 millions (protection buyer)

Bank B contingent payment to A in the event of default of reference asset C (protection seller)


Bank A pays periodically the premium to Bank B

CDS on C is quoted 52 bps (per annum)

Premium= notional Amount x CDS spread

= 10,000,000 x 0.0052 = 52,000


After one year:

C defaults on the bond by declaring bankruptcy

Market value falls to 48.63% of its par value

because

Market expectation is that C will only be able to pay back 48.63% of total outstanding


The payoff on default will be calculated as follow

Notional principal x Par Value – Market Value 100


Bank B makes payment to Bank A

USD 10,000,000 x (100–48.63)/100 =USD 5,137,000


Net effect

CDS allowed Bank A to insulate itself from credit risk by holding the risky bond C

The payoff from sale of reference asset:

USD 10,000,000 x 48.63 = 4,863,000


Bank A receives the recovery rate from the sale of the underlying reference asset USD 4,863,000 and payoff of USD 5,137,000 from Bank B

Total 10,000,000

Bank B acquired the credit risk of holding the bond without actually holding it in return for receiving the premium from BankA

Use of CDS

•Hedging

Protection buyer owns the underlying credit asset

•Speculation

Protection buyer does not have to own the underlying asset

Hedging

CDS manage the credit risk

Protection buyer hedge their exposure by entering into CDS contract

IF reference asset defaults the proceeds from CDS will cancel out the losses on the underlying

Protection buyer will have lost only the payments over that time

IF reference asset does not default protection buyer makes the payments reducing investments returns but eliminates the risk of loss due to reference entity defaults

Speculation

Investor speculates on changes in an entity’s credit quality

If credit worthiness declines => CDS spread will increase

If credit worthiness increases => CDS spread will decline

Example: a hedge fund believes an Entity will default soon buys protection

Speculation

IF reference asset defaults

Protection buyer will have paid the premium but will receive from the protection seller the notional amount making a profit.

IF reference asset does not default

CDS contract will run for whole duration without any return

Speculation

The hedge fund could liquidate its position after a certain period of time lock in its gains or losses

IF reference asset is more likely to default => CDS Spread widens

So, hedge fund sells protection for the rest of CDS duration at a higher rate => makes profit (given that reference asset does not default during this time)

IF reference asset is much less likely to default => CDS spread tightens

So, hedge fund again sells protection for the rest of CDS duration in order to eliminate the loss that would have occurred

credit derivatives. a credit derivative financial instrument allows participants to decouple credit...

Documents

credit risk credit risk

credit events

credit default swaps

line of credit

credit risk exposure

debtors credit rating

credit exposure speculation

cds payment