Credit Derivatives

1. Credit Derivatives

2. credit derivatives 2 Credit Derivatives Credit Derivatives and Its Growth Credit Default Swaps (CDS) Binary Credit Default Swaps Total Return Swaps CDS Forwards CDS Options Collateralized Debt Obligations (CDO) Synthetic CDOs

3. credit derivatives 3 Credit Derivatives A credit derivative is a bilateral contract that isolates specific aspects of credit risk from an underlying instrument and transfers the risk between the two parties Allows replication, hedging and transfer of credit risk Demand created by Specific types of credit risk can be added to a portfolio without acquiring the credit asset itself Credit risks of instruments can be managed Broader range of investors can deal in credit Regulatory capital arbitrage

4. credit derivatives 4 Credit Derivatives Financial contracts with a payout linked to: Loan or bond values Default or credit events Credit spreads Credit ratings With cash settlement or delivery of the relevant underlying asset or portfolio, if appropriate � On single name, baskets, indices � Delivery as notes or OTC contracts � Delivery as swaps or options

5. credit derivatives 5 Credit Derivatives 1992: First use of the phrase �credit derivative� by ISDA 1993-5: Market does not take off S&P refuse to rate credit derivative products Doubt among practitioners whether credit derivative deals that had been done would be completed 1996: Vast range of applications for credit derivatives realised 1997: First synthetic securitisation (JP Morgan�s Bistro deal) 1999: ISDA issued series of definitions, including credit events, obligations and settlement (physical or cash). By end of year, 84% of structures were based on these definitions 1999-: Period of sharp growth in credit derivative market

6. credit derivatives 6 Credit Derivatives

7. credit derivatives 7 Credit Derivatives First generation � Total return swap � Credit default swap � Default digital � Spread options � Second generation � Floating rate asset derivatives � Fixed coupon asset derivatives � Rating option � Bankruptcy swap � Third generation exotics

8. credit derivatives 8 Credit Derivatives Total Return Swaps Party A pays any total positive returns on the underlying asset (including interest and capital appreciation) � Party B pays a funding payment (LIBOR + margin) and any capital depreciation Party A transfers all the credit risk of the underlying asset to Party B without the selling the asset

9. credit derivatives 9 Credit Derivatives Credit Default Swaps Party A pays a fee of x basis points until default or maturity � Party B pays an agreed notional amount upon credit event (relative to an underlying reference loan or security) Party A can take cost of swap into account in pricing the loan and remove credit default risk of perhaps a valued customer

10. credit derivatives 10 Credit Derivatives Credit Spread Derivatives Credit spread is primarily used as compensation for the possibility of default � Two general formats of credit spread � Absolute spread: the credit spread relative to a benchmark that is regarded as default risk free � Relative spread: the spread between two credit-risky assets � Forwards and options on the credit spread � Call options give the purchaser the right to buy the spread � Seller benefits from a decreasing spread � Allows the trading of credit spreads as an isolated variable without being exposed to interest rate risk

11. credit derivatives 11 Credit Derivatives Credit Linked Notes Credit derivative embedded in a fixed-income security � Structure of a credit-default note (where the embedded derivative is a credit-default swap) Both total return swaps (total rate of return credit-linked notes) and credit-spread forwards (credit-spread notes) are also often used as the embedded derivative

12. credit derivatives 12 Credit Derivatives Credit Events: According to ISDA, credit events are � Bankruptcy � Obligation acceleration � Obligation default � Failure to pay � Repudiation/Moratorium � Restructuring � Bankruptcy swap: same structure but only pays out upon bankruptcy; wasoffered by EnronCredit.com � Rating option: same structure but event that triggers payment is an upgrade or downgrade by a rating agency � Can be extended to portfolios � First to default pays out when one credit in a protected portfolio defaults � �m to default� swap

13. credit derivatives 13 Credit Derivatives Breakdown of Credit Derivatives in 2000

14. credit derivatives 14 Credit Derivatives Applications of Credit Derivatives 1. Transfer credit risk of valued customer to another institution � Dynamic management of credit risk � Gain exposure to restricted markets � Yield enhancement � Regulatory capital arbitrage

15. credit derivatives 15 Credit Derivatives Applications of Credit Derivatives 2. Gain Exposure to Restricted Markets / Yield Enhancement Fund wants high yield investment � Emerging markets � Problem of investment restrictions � Typical: cannot invest below BBB grade debt

16. credit derivatives 16 Credit Derivatives Applications of Credit Derivatives 2. Gain Exposure to Restricted Markets / Yield Enhancement

17. credit derivatives 17 Credit Derivatives Applications of Credit Derivatives 3. Regulatory Capital Arbitrage OECD Banks A and B compete to give a loan of �10m to Company X � Risk-weighting is 100% since counterparty is a corporate � Regulatory capital is therefore �800,000 � Banks must raise �9.2m from third-parties

18. credit derivatives 18 Credit Derivatives Applications of Credit Derivatives 3. Regulatory Capital Arbitrage

19. credit derivatives 19 Credit Derivatives Applications of Credit Derivatives 3. Regulatory Capital Arbitrage Banks now co-operate by entering into a credit default swap � Bank A�s counterparty is now an OECD bank (Bank B): risk-weighting 20% � Regulatory capital is therefore �160,000 � Must raise �9.84m from third-parties � Bank B�s counterparty remains Company X and so must still hold �800,000 of regulatory capital

20. credit derivatives 20 Credit Derivatives Applications of Credit Derivatives 3. Regulatory Capital Arbitrage

21. credit derivatives 21 Credit Derivatives Applications of Credit Derivatives 3. Regulatory Capital Arbitrage Bank A�s income is reduced as it is now paying a credit default swap fee of x basis points per annum � Bank A�s return on capital (net income / regulatory capital) increases under the credit default swap arrangement for values for x < 60bp � Bank B�s net income (and thus return on capital) increases for values for x > 33bp � If feasible then regulatory capital arbitrage can occur and the return on capital for both banks can increase by entering a credit default swap with each other

22. credit derivatives 22 Credit Default Swap The most popular credit derivative. The market started to grow fast in the late 1990s. By 2003 notional principal totaled $3 trillion. Credit derivatives are contracts where the payoff depends on the creditworthiness of one or more companies or countries. Buyer of the instrument acquires protection from the seller against a default (credit event) by a particular company or country (the reference entity).

23. credit derivatives 23 Credit Default Swap The buyer of the insurance obtains the right to sell bonds issued by the company for their face value when a credit event occurs. The total face value of the bonds that can be sold is known as the credit default swap�s notional principal. The buyer of the CDS makes periodic payments to the seller until the end of the life of the CDS or until a credit event occurs. These payments are typically made in arrears every quarter, every half year, or every year. The settlement in the event of a default involves either physical delivery of the bonds or a cash payment.

24. credit derivatives 24 Credit Default Swap (cont) Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X Premium is known as the credit default spread. It is paid for life of contract or until default If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are typically deliverable)

25. credit derivatives 25 Credit Default Swap (cont)

26. credit derivatives 26 Credit Default Swap (cont) Suppose payments are made quarterly in the example just considered. What are the cash flows if there is a default after 3 years and 1 month and recovery rate is 40%?

27. credit derivatives 27 Details of Contractual Agreement THE BUYER OF THE CDS MAKES PERIODIC PAYMENTS UNTIL THE END OF THE LIFE OF THE CDS OR UNTIL A CREDIT EVENT OCCURS (IN ARREARS) SETTLEMENT OCCURS @ DEFAULT BY PHYSICAL DELIVERY OF BONDS &/OR CASH PAYMENT

28. credit derivatives 28 Example Say a 5 yr CDS begins on 3/1/04 Assume a notional principle of $100 Million and the buyer agrees to pay 90 basis points annually for protection against default by the entity If there is no default the insurer gets pmts of 900K/yr

29. credit derivatives 29 Example If the contract specifies physical settlement, the buyer has the right to sell bonds issued by the reference entity with a face value of $100m for $100m. If the contract requires cash settlement, an independent calculation agent will poll dealers to determine the mid-market value of the cheapest bonds a pre-designated number of days after the credit event. Suppose this bond is worth $35 per $100 of face value, the cash payoff would be $65m.

30. credit derivatives 30 Example The payments from the buyer of protection to seller of protection cease when there is a credit event. But, since payments are in arrears, there is a final accrual payoff payment. For the example, the buyer would be required to pay the seller the amount of the annual payment accrued between March 1, 2007, and June 1, 2007 (approximately $225,000).

31. credit derivatives 31 CDS SPREAD The total amount paid per year, as a percent of the notional principal, to by protection is the CDS spread. A market maker on CDS might bid 250 basis points and offer 260 basis points. This means that the market maker is prepared to buy protection by paying 250 basis points per year and to sell protection for 260 basis points per year.

32. credit derivatives 32 Recovery Rate (R) R = %Bond FV p. default The recovery rate for a bond is normally defined as the bond�s value immediately after a default as a % of Face Value PAY-OFF = the amount of cash given in settlement = L(1-R) where [L=Notional Principle]

33. credit derivatives 33 A CDS can be used to hedge a position in a corporate bond. Suppose an investor buys a 5 yr, 7% yield corporate bond for its FV with CDS spread 2%/yr (the value of the CDS), and, AT THE SAME TIME, buys protection against the issuer of the bond in a 5yr CDS The CDS effectively converts the corporate bond into a risk-free bond(~) CDSs and Bond Yields

34. credit derivatives 34 A CDS can be used to hedge a position in a corporate bond. Suppose that an investor buys a 5-yr corporate bond yielding 7% per year for its face value and at the same time enters into a 5-yr CDS to buy protection again the issuer of the bond defaulting. Suppose that the CDS spread is 2% per annum. The effect of the CDS is to convert the corporate bond to a risk-free bond. If the bond issuer doesn�t default, investor earns 5%/yr. IF Default, investor earns 5%/yr to date of default, can swap the defaulted bonds for FV and can reinvest the FV @ risk free rates for the remainder of the 5 years. CDSs and Bond Yields

35. credit derivatives 35 Spread = n-year corporate bond par yield � n-year risk-free yield IF CDS Spread was markedly less than this, the investor can earn more than the risk-free rate by buying the corporate bond and buying protection. IF CDS Spread was markedly greater than this, the investor could borrow @ less than the risk-free rate by shorting the corporate bond and selling CDS protection. CDS Spreads

36. credit derivatives 36 Mid-market CDS spreads (the ave. of the bid and offer CDS spreads quoted by brokers) are in practice calculated from default probability estimates HOW IT WORKS: 5 part process: Determining Unconditional default and survival probabilities Calculate the PV of expected pmts Calculate the PV of expected payoff Calculate the PV of accrual payment Set PMT=PAYOFF and solve for S, the mid-market spread Valuation of Credit Default Swap

37. credit derivatives 37 Valuation of Credit Default Swap Initial unconditional default probability is a nominally determined rate for the first year. Succeeding conditional default probability are derived for the initial unconditional default probability and preceding conditional probabilities. Working Assumptions: Default always occurs in the middle of the year CDS pmts made once/year @ the end of the year CDS payments are made at a rate of S per year Notional principle =1$

38. credit derivatives 38 Suppose the probability of a reference entity defaulting during a year condition on no earlier default = 2% [Base year default probability Then you can extrapolate the following probability values yr Default Prob. Survival Prob. 1 0.0200 0.9800(1-.02) 2 0.0196(.02*.98) 0.9604(.98*.98) 3 0.0192 (.02*.9604) 0.9412(.98*.98*.98) 4 0.0188 0.9224 5 0.0184 0.9039

39. credit derivatives 39 Valuation of Credit Default Swap year Surv. Prob Expt�d Pmt Disc. Factor PV of Expt�d Pmt 1 .9800 .9800S .9512 .9322S 2 .9604 .9604S .9048 .8690S 3 .9412 .9412S .8607 .8101S* 4 .9224 .9224S .8187 .7552S 5 .9039 .9039S .7788 .7040S TOTAL 4.0704S *.9412Se-.05*3 = .8101S

40. credit derivatives 40 Valuation of Credit Default Swap Calculation of the PV of Expected Payoff Notional Principle=$1 Yr Def. Prob. RR E PO Disc Factor PVEPO .5 .0200 .4 .0120 .9753 .0117 1.5 .0196 .4 .0118 .9277 .0109 2.5 .0192 .4 .0115 .8825 .0102* 3.5 .0188 .4 .0113 .8395 .0095 4.5 .0184 .4 .0111 .7985 .0088 TOTAL .0511 *.0192 X .6 X $1= .0115; .0115e-.05*2.5=.0102

41. credit derivatives 41 Valuation of Credit Default Swap Calculation of PV of accrual pmt Yr Def. Prob. Exp�d A/Pay DF PVEAP .5 .0200 .0100S .9753 .0097S 1.5 .0196 .0098S .9277 .0091S 2.5 .0192 .0096S .8825 .0085S* 3.5 .0188 .0094S .8395 .0079S 4.5 .0184 .0092S .7895 .0074S TOTAL .0426S *a .0192 probability of final accrual pmt half-way through 3rd year. Accrual payment= .5S, so .0192 X .5S= .0096Se-.05 *2.5=.0085S

42. credit derivatives 42 Valuation of Credit Default Swap Putting it all together and solving for the Spread (S) PV of Expected pmts= 4.0704S PV of Accrual pmt = 0.0426S PV of TOTAL pmts 4.1130S PV of TOTAL payoffs= .0511 Set pmts= to payoffs and solve for S 4.1130S=.0511; S=.0124 Mid-market Spread (S) should be 0.124 times the principal or 124 basis points per year

43. credit derivatives 43 Compute the Value of a CDS Probabilities are known, use CDS spreads (As discussed earlier) Probabilities are unknown, but mid-market CDS spreads are known Two-step procedure: Estimate the risk-neutral default probabilities Estimate the recovery rate

44. credit derivatives 44 Estimation of default probabilities

45. credit derivatives 45 Estimation of default probabilities (continued) How to determine risk-neutral probabilities The prices of bonds issued by the reference entity provide the main source of data for the estimation. If we assume that the only reason a corporate bond sells for less than a similar Treasury bond is the possibility of default, then Value of treasury bond-value of corporate bond = present value of cost of defaults

46. credit derivatives 46

47. credit derivatives 47

48. credit derivatives 48 The valuation requires estimates of the amount claimed by bondholders in the event of a default and the expected recovery rate. If recovery rate is non-zero, it is necessary to make an assumption about the amount the bondholders will claim in the event of default. The claim can be assumed to equal to face value of the bond plus accrued interest. The market value of the reference obligation just after default is the recovery rate times the sum of its face value and accrued interest. So the payoff from CDS is L-R*L[1+A(t)] = L*[1-R-A(t)] Where L is the notional principal & R is the recovery rate A (t) is the accrued interest on the reference obligation at time t as a percent of its face value Estimation of Expected Recovery Rate

49. credit derivatives 49 Binary Credit Default Swaps Same structure as a regular credit default swap except the payoff is a fixed dollar amount. First calculate the present value of expected payment (in terms of s) Second calculate the present value of expected payoff Finally calculate the present value of accrual payment (in terms of s) Then Present value of payments (in terms of s) = expected value of expected payoff

50. credit derivatives 50 Total Return Swaps Swap where one party agrees to pay the other the "total return" of a defined underlying asset, usually in return for receiving a stream of LIBOR based cash flows. This is not a common type of Credit Derivative. Most commonly used with equity indices, single stocks, bonds and defined portfolios of loans, mortgages and leases. It is a mechanism to accept the economic benefits of asset ownership without utilizing the balance sheet.

51. credit derivatives 51 Total (Rate of) Return Swaps Is a financial contract designed to transfer credit risk between parties.( TR Payer and TR Receiver) Payments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument. The payer pays to the receiver the total return of an specified Asset The change-in-value payment is equal to any appreciation (positive) or depreciation (negative) in the market value of the Reference Obligation. TR Return Swaps are often used as financing tool.

52. credit derivatives 52 Total (Rate of) Return Swaps (Cont)

53. credit derivatives 53 Examples of Total Return Swaps Loan Swap: Assume Bank �BBB� has a 5 yr fixed rate 5.5% loan to Company �AAA� This loan is an asset on Bank�s balance sheet. An investor seeking investment diversification, may enter on a Total Return Swap with Bank �BBB� In this transaction the investor is entitle to the total returns of the loan, including interest and any default shortfall. In return the bank will receive LIBOR plus 55 bp to compensate for the use of its balance sheet.

54. credit derivatives 54 Examples of Total Return Swaps Equity Index Swap Investor willing to match the performance of S&P 500. He can buy ETF stocks or S&P 500 stocks. OR Total Return Swap based upon the S&P500 index for 2 Years. Every 6 months the investor would receive the total return of the index and pay LIBOR plus 30bp. No management costs, and he doesn�t have to fund the position in stocks. ( Off Balance Sheet )

55. credit derivatives 55 Total Return Swaps Motivation The Receiver : To take advantage of Leverage. No initial cash payment. No upfront collateral is required. The Payer: Creates a hedge for both price and default risk. Lock in a return and take a negative view on its own asset. Defer loss without risking even more losses.

56. credit derivatives 56 CDS Forwards Forward Is the obligation to buy or sell a particular credit default swap in the future. Example: Forward contract to sell 3 years protection on Delta Airlines Credit for 290 bp starting next year. If the company defaults during next year the banks obligation ceases.

57. credit derivatives 57 CDS Options

58. credit derivatives 58 Collateralized Debt Obligations A way of creating securities with widely different risk characteristics from a portfolio of debt instruments. Assets, called collateral, usually comprise loans or debt instruments. Investors bear the credit risk of the collateral. CDO provides a way of creating high quality debt from average quality debt.

59. credit derivatives 59 Collateralized Debt Obligations Multiple tranches of securities are issued by the CDO, offering investors various maturity and credit risk characteristics Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults of the CDO�s or the CDO�s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, while scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches.

60. credit derivatives 60 Collateralized Debt Obligations Senior and mezzanine tranches are typically rated. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranche is afforded by tranches that are subordinate to it. Senior tranches receive ratings of A to AAA. Mezzanine tranches receive ratings of B to BBB.

61. credit derivatives 61 Collateralized Debt Obligations A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other FI�s or investment managers. The creator of the CDO normally retains the subordinate tranche and sells the remaining tranches in the market.

62. credit derivatives 62 In its simplest form, a CDO is a debt security issued by a special purpose vehicle and backed by a diversified loan or bond portfolio:

63. credit derivatives 63 Synthetic CDO The creator of the CDO sells a portfolio of credit default swaps to third parties. It then passes on the default risk to the synthetic CDO�s tranche holders. Synthetic deals can be created in greater size than cash deals, and avoid the currency and interest rate risk of most cash based CDOs.

64. credit derivatives 64 Typical Synthetic CDO Structure

65. credit derivatives 65 Alternative Structure An alternative structure for a synthetic CDO (or a cash CDO) is where the first tranche agrees to absorb losses from the first X% of companies that default (as opposed to the first X% of losses). The second tranche agrees to absorb the losses from the next Y% of defaulting companies, and so on.

66. credit derivatives 66 4 Good Reasons for CDO Business Spread arbitrage opportunities Regulatory capital relief Funding Economic risk transfer