Applications of Credit Derivatives

Diplomarbeit von Harald Seemann

Abstract:

The purpose of this thesis is to give a general introduction to the credit derivatives market and its instruments. The analytical focus will be about the business fields where credit derivatives are applied. This work aims to analyze the usage of credit derivatives in economic life and describes the different financial players who are involved in those deals. Explanations for certain decisions and credit views are presented. The reader should get a better understanding of these complex financial structures and their importance for businesses, banks and the overall global financial system. The pricing of such pooled financial structures is not as simple as the pricing of a stock or a bond; therefore selected pricing models are presented with the intention to show all the different factors which determine credit spreads and finally the price of a credit derivative. The thesis concludes with an evaluation of this young, but highly dynamic market, including the role and responsibility of regulators. Opportunities and threats are outlined, so that the reader is able to draw an opinion about these modern financial instruments.

This study begins with a general introduction to the credit derivatives market and gives arguments for the growth catalysts which have driven the development to the current state. The financial participants in this market are presented as well. A comparison between market risk and credit risk follows to show the clear transition that helped credit risk to become an asset class. After that, a link to the recent Basel II guidelines is established in order to show the policies that banks have to consider when trading with credit risk.

Chapter 2 deals with the historical evolution of credit derivatives and classifies different structures. A presentation of the main types of credit derivatives and their contract elements follow; these are mainly credit default swaps (CDS) and collaterized debt obligations (CDO). Chapter 2 also deals with definitions of a credit event and the calculation of risk premiums. Forms of default payment illustrate the possible settlement of a credit derivative contract. Afterwards, an account of the International Swaps and Derivatives Association (ISDA) is presented. This association serves as a supplier of standardized documentation to all market participants and facilitates transactions.

Chapter 3 is the key element of this thesis and shows the applications of credit derivatives: they serve as portfolio diversifiers for asset managers, hedging instruments for banks or corporations and offer arbitrage possibilities for hedge funds and other institutions that monitor mispricings in bond and credit markets. This part delivers essential information for the final evaluation of such instruments from a practical point of view in Chapter 5.

In Chapter 4, the thesis covers the most important pricing tools for credit derivatives. Three generally accepted and widely used models are presented and evaluated concerning their suitability for various parties. These models vary greatly. Recently, a German governmental organization has set a standard evaluation system in place; whereas multinational investment banks form their own capacities in house or through joint ventures. An efficient valuation system gives market participants a major competitive advantage because they can observe default probabilities on an ongoing basis under changing market conditions.

Chapter 5 deals with an evaluation of credit derivatives from a practical point of view and discusses the opportunities and risks involved in credit derivatives. The author concludes with a critical evaluation about the role and responsibility of regulators in this market and a view on the current situation of the global credit markets.

Table of Contents:

	Illustration Index	2
	Table Index	3
	Abbreviation Index	5
	Index of Appendices	5
1.	Current Issue	6
1.1	Purpose of the thesis	8
1.2	Structure of the thesis	9
2.	Credit Risk Management - Foundations	10
2.1	Credit Risk versus Market Risk	10
2.2	Impacts of Basel II	11
2.3	Classification and Evolution of Credit Derivatives	12
2.4	Main Types of Credit Derivatives	14
2.4.1	Total Return Swap	15
2.4.2	Credit Default Swap	16
2.4.2.1	Variations of Credit Default Swaps	17
2.4.3	Credit Linked Notes - Rationale	18
2.4.3.1	Collaterized Debt Obligation	20
2.4.3.2	Synthetic Collaterized Debt Obligation	21
2.5	Contract Characteristics	23
2.5.1	Reference Asset	23
2.5.2	Risk Premium	24
2.5.3	Credit Event	25
2.5.4	Recovery Rate	28
2.5.5	Forms of Default Payment	31
2.5.5.1	Cash Settlement	31
2.5.5.2	Physical Settlement	31
2.6	Standardized Documentation	32
2.6.1	International Swaps and Derivatives Association	32
2.7	Succession of CDS Reference Entities	34
3.	Applications of Credit Derivatives	36
3.1	Portfolio Diversification	36
3.2	Short Positioning	36
3.3	Concentration Risk	37
3.4	Hedging	42
3.4.1	Distressed Buyer	42
3.4.2	Vendor Financing	43
3.4.3	Leasing Exposure	44
3.4.4	Managing Funding Cost Risk	45
3.4.5	Synthetic Debt Repurchase	47
3.5	Basics of Target Profiles	48
3.5.1	Cash Bonds versus Synthetic Securitization	48
3.6	Regulatory Arbitrage	49
4.	Pricing of Credit Derivatives	52
4.1	Firm Value Model	53
4.1.1	Valuation Approach	54
4.1.2	Advantages and Disadvantages of the Firm Value Model	58
4.1.3	Moody's KMV Risk Management Tools today	59
4.1.4	Equity Prices and Bankruptcy	60
4.2	Market Pricing Model for Credit Correlation Products	61
4.2.1	100% Credit Default Correlation	64
4.2.2	-100% Credit Default Correlation	65
4.2.3	0% Credit Default Correlation	66
4.2.4	Findings from Default Correlation Analysis	67
4.3	Credit Rating Transition Models	68
4.3.1	Valuation Approach	68
4.3.2	Advantages and Disadvantages of Credit Rating Transition Models	70
5.	Evaluation of Credit Derivatives	72
5.1	Opportunities and Risks involved in Credit Derivatives	72
5.2	Role and Responsibility of Regulators	76
5.3.	Credit Derivatives in the Global Credit Markets	77
	Bibliography	79

Text Sample:

Chapter 2.4.3, Credit Linked Notes – Rationale:

The size of the bond markets compared to the amount of existing credit risk shows a huge gap. Bond markets do not reveal all the credit risk. Even if bonds have always played an important role in funding activities of corporations, they were mainly accessible to large, rated issuers with considerable funding needs. Furthermore, bond markets are still dominated by government bonds, which limit exposure of a corporation to credit risk.

Outside the major European and North American high yield markets, there is limited availability of bonds from non-investment grade issuers. This makes it difficult to create diversified investment portfolios. Credit risk can only be taken through the purchase or sale of a bond and is restricted to institutional market participants. The direct bond market does not provide investors with the ability to create structured exposure to credit risk which becomes an emerging need in a more and more complex financial world. Lack of liquidity and high transaction costs scare investors from investing in certain types of fixed income assets. Structuring of credit risk in credit linked notes helps to avoid this deficit.

These circumstances drive investment interest in credit risk exposure. Furthermore, reduced government deficits in certain western countries (e.g. the United Kingdom, Australia and Canada) lead to a short supply of fixed income securities. This makes investors search for substitutions to the corporate bond universe.

Credit risk has quickly gained recognition and is considered an asset class nowadays. The returns on credit risk are considerable and low correlation to other asset classes such as equities, real estate, currencies or commodities support portfolio diversification needs to achieve risk adjusted return on capital. Furthermore, credit risk offers different segments of volatility (credit spreads and actual default) and offers a full range of trading opportunities to active players like banks and financial institutions on the market.

Credit linked notes offer significant benefits to investors. They enable investors to rate a security based on the credit risk of both the issuer and the reference credit with an expected loss approach. The rating of a credit linked note is derived from the probability of default and loss given default of the issuer and the defined reference entity of the credit linked note.

Regulatory treatment of credit linked notes is not complicated for the issuers, because they fully cash collateralise against loss through default or a specified credit event. This means that there is no capital requirement for the issuer in respect of the counterparty risk of the seller of default protection. The seller of credit protection has to hold sufficient capital requirements against the higher risk carried party among the issuer and the underlying reference credit.

Collaterized Debt Obligation:

Collaterized Debt Obligations (CDOs) can basically be of two types: balance sheet CDOs and arbitrage CDOs. Balance sheet CDOs are those which result in transfer of loans from the balance sheet and hence impact the balance sheet of the originator. Arbitrage CDOs are those in which the originator is merely a repackager, e.g. asset management companies: buying loans or bonds or asset backed securities from the market, pooling them together and securitizing the same. The prime objective in balance sheet CDOs is the reduction of regulatory capital and the enhancement of return on capital, while the evident purpose in arbitrage CDOs is making arbitraging profits from market inefficiencies. When the assets yield more than structured liabilities plus fees, the arranger gets the arbitrage spread.

Balance sheet CDOs can be further classified into cashflow CDOs and synthetic CDOs. Synthetic CDOs are the most common ones used as explained in detail in the following sections.

Cashflow CDOs are the usual CDO tranches where the originating bank transfers a portfolio of loans into a Special Purpose Vehicle (SPV). Master trust structures are commonly employed in CDOs to enable the bank to keep transferring loans into the pool on a regular basis without having to do complex documentation every time. Commercial loans are not regular-repaying in the sense of mortgage loans or auto loans. Hence, there is no question of regular retirement of CDOs like pass troughs in the mortgage market. Most of the cash flow CDOs repay by way of bullet loans at the end of maturity. Synthetic CDOs do not intend to raise cash by transferring loans, but instead merely transfer the risk inherent in the loans.

The first CDOs emerged in the late 1990s and were basically imitations of a mortgage-backed security structure with banks who had given out corporate loans. Banks took their bonds and loans to corporate clients and sold them to a SPV; the SPV issued debt in the capital markets and the money raised was used to pay for the loans. It should be noted that the SPV belongs to the bank. It is an independent legal entity to facilitate the sale process to investors and unlike a bank security, it is entirely unregulated because the loans are shifted outside the reach of regulators.

The SPV passed the CDOs in different risk tranches on to investors. Borrowers were not always satisfied with the shifting of their loans from one financial institution to another and so the banks searched for an efficient way to offer the portfolios of bonds and loans to investors while maintaining the original lender – borrower relationship and pooling the credit risk on loans and bonds. The idea of the modern synthetic securitization process of CDOs was born. The CDO consists of a portfolio of CDSs. More precisely, the bank does not sell its loans; instead it enters into a CDS on the loans with the SPV. Synthetic CDOs enable investors to repackage credit risk and apply leverage to a credit position.

Synthetic Collaterized Debt Obligation:

Synthetic CDOs allow investors to tailor their risk exposure to a large and diversified credit portfolio through different tranches of synthetic securitization. A synthetic CDO is an investment in which the underlying collateral is a portfolio of single-name credit default swaps.

The SPV is an entity which owns loans indirectly on the one side and has equity, mezzanine and normal debt on the other side. These liabilities are issued in the form of multi-tranche credit linked notes (CLNs) with credit ratings from triple-A through non-rated equity. The funds collected from the investors are not used to purchase collateral, but to create a credit support account, and are usually invested in safe and liquid assets like government bonds to absorb losses in the case of a default on any of the reference assets. On a regular basis, the CDS premiums combined with the interest from the cash collateral account are paid to the investors according to a pre-defined priority of payments.

Following a credit event, a trustee is expected to liquidate assets from the cash collateral account in an amount equal to the losses used to pay the protection buyers. This typically leads to a write-down of liability principal. For example, the first tranche to experience losses due to credit events is the equity tranche, then the mezzanine tranche (BBB-rated notes) and afterwards only the senior notes.

Illustration 5 shows an “unfunded” senior tranche of 800 million Euros in which investors do not put up cash, but are paid a premium to enter into a default swap with the SPV. This unfunded risk transfer creates a more efficient capital structure. For example if there are 100 firms with loans of 10 million Euros each in the portfolio, equity and mezzanine investors take the risk of the first seven firms out of the 100 in the portfolio to default.