Harald Seemann
Applications of Credit Derivatives
Opportunities and Risks involved in Credit Derivatives
ISBN: 978-3-8366-0842-8
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Zugl. Fachhochschule Regensburg, Regensburg, Deutschland, Diplomarbeit, 2007
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Harald Seemann - Applications of Credit Derivatives
1
Applications of Credit Derivatives
Table of Contents
Page
Illustration Index... 3
Table Index ... 4
Abbreviation Index ... 5
Index of Appendices ... 5
1. Current Issue ... 7
1.1. Purpose of the thesis... 9
1.2. Structure of the thesis... 10
2. Credit Risk Management - Foundations... 11
2.1. Credit Risk versus Market Risk ... 11
2.2. Impacts of Basel II ... 12
2.3. Classification and Evolution of Credit Derivatives... 13
2.4. Main Types of Credit Derivatives... 15
2.4.1. Total Return Swap... 16
2.4.2. Credit Default Swap ... 17
2.4.2.1. Variations of Credit Default Swaps ... 18
2.4.3. Credit Linked Notes Rationale... 19
2.4.3.1. Collaterized Debt Obligation ... 21
2.4.3.2. Synthetic Collaterized Debt Obligation ... 22
2.5. Contract Characteristics ... 24
2.5.1. Reference Asset... 24
2.5.2. Risk Premium... 25
2.5.3. Credit Event... 26
2.5.4. Recovery Rate ... 29
2.5.5. Forms of Default Payment ... 32
2.5.5.1. Cash Settlement... 32
2.5.5.2. Physical Settlement ... 32
2.6. Standardized Documentation ... 33
2.6.1. International Swaps and Derivatives Association... 33
2.7. Succession of CDS Reference Entities... 35
Harald Seemann - Applications of Credit Derivatives
2
3. Applications of Credit Derivatives... 37
3.1. Portfolio Diversification... 37
3.2. Short Positioning... 37
3.3. Concentration Risk... 38
3.4. Hedging ... 43
3.4.1. Distressed Buyer ... 43
3.4.2. Vendor Financing... 44
3.4.3. Leasing Exposure ... 45
3.4.4. Managing Funding Cost Risk... 46
3.4.5. Synthetic Debt Repurchase ... 48
3.5. Basics of Target Profiles ... 49
3.5.1. Cash Bonds versus Synthetic Securitization ... 49
3.6. Regulatory Arbitrage... 50
4. Pricing of Credit Derivatives... 53
4.1. Firm Value Model ... 54
4.1.1. Valuation Approach ... 55
4.1.2. Advantages and Disadvantages of the Firm Value Model... 59
4.1.3. Moody's KMV Risk Management Tools today... 60
4.1.4. Equity Prices and Bankruptcy ... 61
4.2. Market Pricing Model for Credit Correlation Products ... 62
4.2.1. 100% Credit Default Correlation ... 65
4.2.2. -100% Credit Default Correlation ... 66
4.2.3. 0% Credit Default Correlation ... 67
4.2.4. Findings from Default Correlation Analysis... 68
4.3. Credit Rating Transition Models... 69
4.3.1. Valuation Approach ... 69
4.3.2. Advantages and Disadvantages of Credit Rating Transition Models ... 71
5. Evaluation of Credit Derivatives ... 73
5.1. Opportunities and Risks involved in Credit Derivatives... 73
5.2. Role and Responsibility of Regulators... 77
5.3. Credit Derivatives in the Global Credit Markets ... 78
Bibliography ... 81
Harald Seemann - Applications of Credit Derivatives
3
Illustration Index
Illustration 1: Global Credit Derivatives Market Growth ... 8
Illustration 2: Most common product types among Credit Derivatives ... 15
Illustration 3: Funded structure of a Total Return Swap... 16
Illustration 4: Graphical illustration of a Credit Default Swap ... 18
Illustration 5: Synthetic Collaterized Debt Obligation... 23
Illustration 6: Cash Flows without a Credit Event ... 29
Illustration 7: Cash Flows with Credit Event (Physical Settlement)... 29
Illustration 8: Example for Succession of CDS Reference Entities ... 36
Illustration 9: Nokia raises funds and hedges credit risk of the Algerian operator... 44
Illustration 10: Elad Properties monetizes the lease - sale of its credit risk on Rite Aid ... 45
Illustration 11: Example of Synthetic Debt Repurchase from Wal-Mart... 48
Illustration 12: Distribution of terminal firm value at maturity of debt ... 58
Illustration 13: Global Loan Defaults from 1996 to 2005... 62
Illustration 14: Global Bond Defaults from 1996 to 2005 ... 62
Illustration 15: Default Realization in a Venn diagram ... 64
Illustration 16: 100% Credit Default Correlation... 65
Illustration 17: -100% Credit Default Correlation ... 66
Illustration 18: 0% Credit Default Correlation... 68
Harald Seemann - Applications of Credit Derivatives
4
Table Index
Table 1: Classification and Evolution of Credit Derivatives ... 13
Table 2: Example of a Reference Asset ... 24
Table 3: Average Recovery Rates by Industry... 31
Table 4: An example of the effect of diversification on portfolio credit risk ... 41
Table 5: 5-year Funding Levels ... 44
Table 6: Credit spread structure of Continental for different maturities... 46
Table 7: Balance sheet CDO introduction... 50
Table 8: CDO Capital Structure ... 51
Table 9: Regulatory Capital Position before CDO Transaction... 51
Table 10: Regulatory Capital Position in a Traditional CDO ... 51
Table 11: Regulatory Capital Position in a Synthetic CDO... 51
Table 12: Balance sheet CDO Net Capital Savings ... 52
Table 13: Ongoing Benefit each year from Traditional and Synthetic CDOs ... 52
Table 14: Balance Sheet CDO Return on Capital ... 52
Table 15: Simplified Example of Firm Value Model ... 56
Table 16: EDF versus Ratings agency default measures ... 56
Table 17: Comparison of Credit Default Swap and Equity Default Swap... 61
Table 18: Nth-to-default basket vs. Synthetic CDO ... 63
Table 19: Sample Basket for a Credit Correlation Product... 64
Table 20: Cumulative default probabilities in percent from 1970 - 2003 by Moody's ... 70
Table 21: Marginal default probabilities in percent from 1970 - 2003 by Moody's ... 70
Harald Seemann - Applications of Credit Derivatives
5
Abbreviation Index
BCBS
Basel Committee on Banking Supervision
BIS
Bank for International Settlements
CDO
Collaterized Debt Obligation
CDS
Credit Default Swap
CLN
Credit Linked Note
EAD
Exposure at Default
EDF
Expected Default Frequency
EDS
Equity Default Swap
FSA
Financial Services Authority in the United Kingdom
IAS
International Accounting Standards
IRB
Internal Rating Based
ISDA
International Swaps and Derivatives Association
KDB
Korean Development Bank
LBO Leveraged
Buyout
LGD
Loss Given Default
LIBOR
London Interbank Offered Rate
MTM
Mark To Market
OECD
Organisation for Economic Co-operation and Development
OTC
Over The Counter
PD
Probability of Default
RoC
Return on Capital
SPV
Special Purpose Vehicle
S&P
Standard & Poor's
VaR
Value at Risk
Index of Appendices
Appendix 1: ISDA's Risk Management Activities... 86
Appendix 2: EXHIBIT A to 2003 ISDA Credit Derivatives Definitions... 88
Harald Seemann - Applications of Credit Derivatives
7
1. Current Issue
The traditional bank credit is a central business activity of financial institutions
1
.
Globalization and the dispersion of large companies have lead to fierce competition in terms
of capital market financings versus classical credit financings. This scenario has increased
product innovation tremendously. As a consequence of rising credit defaults and failed
evaluation of default probabilities during various crises in the past, banks have created an
attractive field of profit to trade credit risks based on a pooled portfolio or on single credits:
the credit derivatives market. It allows trading of credit risks between various parties, ranging
from commercial banks, asset managers, insurance companies, investment banks and hedge
funds to corporations.
Credit derivatives are financial instruments which allow the splitting and transfer of credit
risk without influencing the original credit relationship between the credit originator and the
credit borrower. Credit derivative deals can be negotiated between the counterparts and
transfer only the defined credit risk against payment of a certain risk premium. A risk seller,
the party seeking credit risk protection, may want to reduce exposures while maintaining
relationships that may be endangered by selling their loans, reduce or diversify illiquid
exposures, or reduce exposures while avoiding adverse tax or accounting treatment. A risk
buyer, the party assuming credit risk, may want to diversify credit exposures, get access to
credit markets which are otherwise restricted by corporate statute or which are off-limits by
regulation, or simply exploit arbitrage pricing discrepancies. For example, arbitrage
opportunities in the credit derivatives market result from perceived mispricings between bank
loans and subordinated debt of the same issuer.
At first sight, credit derivatives offer attractive benefits to the counterparts involved. The
transfer of credit risk against a premium makes credit markets more efficient, facilitates credit
offerings from banks to young start ups and supports economic growth and innovation.
Concentration risk can be avoided easily. Compared to bonds, for which companies have to
fulfil huge amounts of regulation documents, credit derivatives do not require long approvals.
Deals are completed directly between counterparts over the counter (OTC) or in cooperation
with the major players in this market.
The legal frame for this market is still underdeveloped and transactions cannot always be fully
tracked by legal authorities. This explains the explosive growth of the credit derivatives
1
See Brealey, Richard A. and Myers, Stewart C. Principles of Corporate Finance, 8
th
edition New York
(McGraw-Hill/Irwin) 2005, Pages 725 736
Harald Seemann - Applications of Credit Derivatives
8
market: the current volume amounts to more than 20.2 trillion US-Dollars
2
on aggregated
terms. Since 2006, the relative size of the credit derivatives market is higher than the
corporate bonds market.
3
Illustration 1: Global Credit Derivatives Market Growth
4
It is interesting to note that the credit derivatives market has tripled in the span of a few years.
Efficient execution and risk management systems as well as high liquidity and easy
accessibility allow market participants to trade credit protection whenever they need it. The
application of credit derivatives reaches a constantly growing target. Hedge funds have
become a major force in the credit derivatives market; their share of volume in both buying
and selling credit protection has almost doubled since 2004. Banks constitute the majority of
market share and almost two-thirds of the volume in credit derivatives by banks is due to
trading and a third is related to their loan book only.
5
2
See British Banker's Association, Credit Derivatives Report 2006 Page 3:
(
http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf
Consulted on
14/04/2007)
3
Salas, Caroline Around The Markets: Technology transforms Bond Market, International Herald Tribune,
10/05/2006: (
http://www.iht.com/articles/2006/05/09/bloomberg/bxatm.php
Consulted on 28/03/2007)
4
Source: British Banker's Association, Credit Derivatives Report 2006 Page 3 - Credit Derivatives Products in
2006 (
http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf
Consulted
on 15/04/2007)
5
See British Banker's Association, Credit Derivatives Report 2006 Pages 4 - 5
(
http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf
Consulted on
15/04/2007)
Harald Seemann - Applications of Credit Derivatives
9
Asset managers sometimes prefer to take a certain credit view of a company in which they see
an opportunity for profit. This is another way to participate in the upside potential rather than
investing directly in the stock.
Another macroeconomic factor explains the explosive growth of the credit derivatives market
as well: the attractive interest rates. This makes money cheap and avoids credit defaults. The
impact of rising interest rates could lead to a decrease in the dynamics of this market.
1.1. Purpose of the thesis
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.
Harald Seemann - Applications of Credit Derivatives
10
1.2. Structure of the thesis
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.
Harald Seemann - Applications of Credit Derivatives
11
2. Credit Risk Management - Foundations
2.1. Credit Risk versus Market Risk
Until the early 1990s, credit and market risk were two different functions within a bank and
had different evaluation methods.
Banks are financial intermediaries originating loans and consequently facing credit risk.
Credit risk
6
can be defined as the risk of losses caused by the default or by the deterioration in
credit quality of a borrower. Default occurs when a borrower cannot meet key financial
obligations to pay principal and interest. Banks increasingly recognize the need to measure
and manage the credit risk of the loans they have originated; not only on a loan-by-loan basis
but also on a portfolio basis. A pre-condition for diversification after the origination of the
loans is their transferability. It is well-known that transferring credit risk of loans is difficult
due to severe adverse selection and ethical issues. For this reason the use of existing tools like
loan sales has not been very successful in transferring the credit risk on a broad scale.
However, in recent years, the developments of markets for credit securitization and credit
derivatives have provided new tools for managing credit risk.
Credit derivatives are often described as "synthetic loans", which reflects their common use
and enormous potential. More broadly defined, credit derivatives
7
are sophisticated financial
instruments that enable the unbundling of credit risk from the credit originator and allow
easier intermediation of credit due the separation of the risks involved in such a transaction.
Market risk
8
is the risk that the value of an investment will decrease due to moves in market
conditions. The four standard market risk factors are:
· Equity risk, or the risk that stock prices will change
· Interest rate risk, or the risk that interest rates will change
· Currency risk, or the risk that foreign exchange rates will change
· Commodity risk, or the risk that commodity prices (i.e. grains, metals, etc.) will
change
Market risk is typically measured using a Value at Risk (VaR) methodology.
9
Market risk can
also be contrasted with specific risk, which measures the risk of a decrease in an investment
due to a change in a specific industry or sector, as opposed to a market-wide move. Value at
6
See Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Pages 1 5
7
See Chris Francis, Atish K., Barnaby M. - Merill Lynch Credit Derivative Handbook, London 2003, Page 3
8
See Joshi, Mark - The Concepts and Practice of Mathematical Finance, 5
th
edition Cambridge (Cambridge
University Press) 2005, Pages 1-15; Brealey, Richard A. and Myers, Stewart C. Principles of Corporate
Finance, 8
th
edition New York (McGraw-Hill/Irwin) 2005, Pages 127 - 136
9
See Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Pages 128 and 135
Harald Seemann - Applications of Credit Derivatives
12
Risk calculates the maximum loss expected (or worst case scenario) on an investment, over a
given time period and given a specified degree of confidence.
Traditionally, credit and market risk had to be distinguished from one to the other, because
credit risk was often based on party-specific factors related to corporate finance while market
risk also covered macroeconomic events. Credit derivatives allow investors to trade credit risk
in very much the same way as market risk.
2.2. Impacts of Basel II
In 1988, Basel I was the first big step towards efficient credit risk management. If a bank
lends to a company, it has to hold a minimum of 8% in equity for every loan. Basel I made the
credit risk specification dependent on the counterparty.
10
The amount of regulatory capital
that had to be held against counterparts for the purchase of e.g. a government bond favoured
Organisation for Economic Co-operation and Development (OECD) members. There was a
weakness in Basel I as countries like Turkey (member of the OECD, credit rating BB) had a
risk weighting of 0%, while countries like Singapore (not a member of the OECD, credit
rating AAA) had a risk weighting of 100%. Even if Singapore had a good credit rating, it
would have been expensive to purchase government bonds from this country due to the equity
requirement. In a world of shareholder value, a bank has to minimize equity to increase its
return. Only the purchase or sale of protection from OECD governments and banks was a
good hedge. Emerging countries like Singapore, Hong Kong, China or India which became
part of a well-diversified global credit portfolio were not considered.
In June 2004, the Basel Committee on Banking Supervision issued the long-awaited
"International Convergence of Capital Measurement and Capital Standards: a Revised
Framework" describing changes to the regulatory capital requirements for banks. These
changes are known as the New Basel Capital Accord, or more commonly as "Basel II." The
new accord, under discussion since June 1999, has been designed to replace the 1988 Basel
accord with a more risk-sensitive set of regulations. A key element of the new accord is
greater reliance on the internal rating systems of the banks in the calculation of regulatory
capital charges.
11
Basel II was adopted by most banking regulators in 2007. The Internal
Rating Based (IRB) approach can only be adopted with regulatory approval and the new
10
See Read, Jonathan P. Advanced Applications of Credit Derivatives, New York (Lecture Notes from
Columbia Business School, USA), 2007, page 352
11
See Read, Jonathan P. Advanced Applications of Credit Derivatives, New York (Lecture Notes from
Columbia Business School, USA), 2007, page 357
Harald Seemann - Applications of Credit Derivatives
13
standardized approach says that the counterparty risk weighting is based on the entity type
and entity rating.
Consequently, the major international banks will choose the IRB approach while smaller
commercial banks are likely to take the standardized approach. Hence there are two
constituencies that have different capital requirements for the same position. A possible
impact of Basel II could be the transfer of sub-investment grade assets from IRB to
standardized approach using institutions. Based on this fact, a future issue of Basel II will be
if risk in commercial banks increases inadvertently or not.
12
Additionally, banks are able to
minimize regulatory capital through an efficient structuring of balance sheet Collaterized Debt
Obligations (CDOs). An explanation of this approach will follow in detail when it comes to
Chapter 3.6. "Regulatory Arbitrage".
2.3. Classification and Evolution of Credit Derivatives
Table 1: Classification and Evolution of Credit Derivatives
13
Credit Event Options Forwards
Swaps Structured
Notes
Changes in
Credit
Spread
Credit Spread
Option
Credit Spread
Forward
Credit Spread
Swap / Total
Return Swaps
Credit Linked Note /
Collaterized Debt Obligation
Default
Credit Default
Option
Credit
Default
Swap
Credit Linked Note /
Collaterized Debt Obligation
Table 1 displays the main types of credit derivatives. When the market in credit derivatives
emerged, the first structures were similar to call and put-options on the underlying credit, in
which the buyer would wager on a certain market movement of the underlying reference
asset. Credit spread products exist in two ways; first relative to the benchmark (absolute
spread) and second between two credit sensitive assets (relative spread). A change in market
value or credit rating could be beneficial or not. Call options on credit spreads would benefit
from a decreasing spread, while put options on credit spreads would benefit from an increase
12
See Read, Jonathan P. Advanced Applications of Credit Derivatives, New York (Lecture Notes from
Columbia Business School, USA), 2007, page 357
13
Table created by the author
Harald Seemann - Applications of Credit Derivatives
14
in the spread. The same accounts for possible default events. In a credit default option,
investors can wager on the fact if one entity defaults ahead of another.
Structurally, credit spread forwards and credit spread swaps are very similar. They are both
structured as a forward rate agreement where at maturity of the contract, there is a net cash
settlement based on the difference between the agreed spread and the actual spread.
This shows that forwards have a linear payoff profile while options have a non-linear payoff
format. The main applications of credit spread derivatives are:
· To benefit from relative credit value changes independent of changes in interest rates
· To trade forward credit spread expectations
· To trade the volatility of credit spreads
Due to the enormous evolution of the credit derivatives market, product innovation never
stops and the trend has gone towards swap and structured note products. As stated above, they
account for the major market share and are the most important instruments for dealers and
investors. For this reason, option and forward products will not be discussed in this thesis.
The focus lies on swaps and structured notes linked to credit.
Harald Seemann - Applications of Credit Derivatives
15
2.4. Main Types of Credit Derivatives
The credit derivatives market is dominated by two major instruments: The Credit Default
Swap (CDS) and the Synthetic Collaterized Debt Obligation (CDO). These two types
represent approximately 50% of the market volume.
14
Synthetic CDOs derive from CDSs and
are often pooled so that they can be offered to investors on a portfolio basis to diversify risk.
Not only the size of the credit derivatives market has grown rapidly but also product
innovation has moved forward quickly. Examples of heavily traded products are e.g. index
trades, tranched index trades
15
and equity-linked products. These simple structures account
for approximately 40% of the market volume.
Illustration 2: Most common product types among Credit Derivatives
16
14
See British Banker's Association, Credit Derivatives Report 2006 Page 4
(
http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf
Consulted on
15/04/2007)
15
Tranched index trades derive from an index, but just comprise certain parts in it
16
Source: British Banker's Association - Credit Derivatives Products in 2006, Credit Derivatives Report 2006
Page 4 (
http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf
Consulted on 15/04/2007)
Harald Seemann - Applications of Credit Derivatives
16
2.4.1. Total Return Swap
A total return swap aims to replicate the total performance of a loan asset
17
and is a way to
pass on changes in credit spreads. The motivation from the viewpoint of the dealer is to get
rid of an asset without entering into a transaction that might upset the borrower, while the
investor seeks to leverage his return in the underlying bond.
Illustration 3: Funded structure of a Total Return Swap
18
· Most total return swap transactions are on traded bonds and loans as security
· The final investor assumes all risk and cash flow of the underlying asset and has to
pay the funding cost for this return
· The dealer has to pass through all the interest payments of the asset to the investor
Since bonds are traded and are subject to price fluctuations over their lifetime, the dealer has
to pay out the investor if the bond trades above par value or the investor has to compensate
the dealer when the bond trades below par. This payoff mechanism is determined at specific
dates over the life of the transaction based on the current market value of the underlying asset.
The investor has to pay the money market return plus a margin as funding cost. This serves to
adjust the return to the purchaser of the underlying bond or loan asset. The final investor does
not own the bond. This enables the investor to fully fund the structure by investing the cash of
the underlying asset in a money market instrument in order to match payments to the dealer.
If the swap maturity matches the one of the reference asset, it is simply a synthetic version of
the asset that allows the dealer to go long or short without funding. Total return swaps exist in
funded and unfunded structures.
17
See Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Pages 8 - 9
18
Source: Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Page 10
Dealer
(=bank)
Investor
(=another bank)
Bond from
company
Cash investment of bond's
nominal value (money market)
Libor + Margin
Bond interest
Bond price changes
Libor
Harald Seemann - Applications of Credit Derivatives
17
2.4.2. Credit Default Swap
Credit Default Swaps (CDSs) have proved to be one of the most successful financial
innovations of the 1990s. Prior to credit derivatives, investors relied on insurance policies to
hedge against losses.
19
The structure of insurance policies is similar to CDSs but there are
some differences. Insurance policies require an underlying insurable interest and actual loss,
while CDSs do not have such a requirement. Credit protection can be bought in both cases:
the buyer has risk exposure to the underlying asset and can decide about a hedging strategy.
Definition
A Credit Default Swap (CDS) is an over the counter (OTC) agreement to transfer a defined
credit risk from one party to another. The buyer of credit protection pays a periodic fee, most
of the time a fixed rate including a premium over the current reference swap rate on the
market in order to price the relevant default risk. This fixed rate protects the buyer against a
"Credit Event" based on the financial status of the entity underlying the CDS contract.
The seller of credit protection takes the credit risk and "bets" on a positive financial
development of the underlying entity in the future and pays a floating rate to the protection
buyer which is most of the time linked to the London Interbank Offered Rate (LIBOR).
It is important to note that a CDS is not settled unless there is a credit event or the CDS
reaches maturity. Market changes of the underlying credit are not taken into consideration.
More concretely, this means that a CDS never transfers any price risk arising from a change
in credit quality.
In general, CDSs deal with the transfer of credit risk between counterparties because of
different market views. They allow the unbundling of credit risk from other transactions so
that credit risk can be traded separately. The sellers of credit protection do not need to be
related to the business of the loan-taking company.
19
See Das, Satyajit, Traders, Guns & Money Knowns and Unknowns in the Dazzling World of Derivatives,
Dorchester (Financial Times Prentice Hall) 2006, Pages 271 - 273
Harald Seemann - Applications of Credit Derivatives
18
Illustration 4: Graphical illustration of a Credit Default Swap
20
2.4.2.1. Variations of Credit Default Swaps
There are a number of variations of the standard credit default swap.
21
The most common
forms used in practice are:
Binary Credit Default Swap
The payoff in the event of a default corresponds to a specific dollar amount. This amount is
determined at the establishment of the contract, depending on the severity of the default.
Basket Credit Default Swap
Here, a group of reference entities are specified and there is a payoff when the first of these
reference entities defaults.
Contingent Credit Default Swap
The payoff requires two factors: A credit event and an additional trigger. The additional
trigger could be a credit event with respect to another reference entity or a specified
movement in some market variable.
Dynamic Credit Default Swap
The notional amount determining the payoff is linked to the mark-to-market value of a
portfolio of swaps.
20
Graph created by the author
21
See Hull, John; White, Alan Valuing Credit Default Swaps I: No counterparty default risk, Toronto (Joseph
L. Rotman School of Management, University of Toronto, Canada), 2000, Page 4
(
http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf
Consulted on 19/05/2007)
Credit Risk Seller
Periodic risk premium
Credit Default Swap
Synthetic Risk Position
Client relationship
Debtor
Credit Risk Seller
Compensation or 0
Harald Seemann - Applications of Credit Derivatives
19
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.
22
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
23
. 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.
22
See Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Page 342
23
See Tzani, Rodanthy, Leibholz, Maria, Gregory, Jon (Editor) - Credit Derivatives: The Definitive Guide, 2
nd
edition London (Risk Books) 2003, Pages 440 - 447
Harald Seemann - Applications of Credit Derivatives
20
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.
Harald Seemann - Applications of Credit Derivatives
21
2.4.3.1. Collaterized Debt Obligation
Collaterized Debt Obligations (CDOs) can basically be of two types: balance sheet CDOs and
arbitrage CDOs
24
. 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
25
. 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
26
. 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.
24
See Das, Satyajit, Credit Derivatives CDOs & Structured Credit Products, 3
rd
Edition Singapore (Wiley
Finance Series) 2005, Pages 308 and 316
25
See Marmery, Nikki The Reason to Issue, Credit Magazine May 2004:
(
http://www.creditmag.com/public/showPage.html?page=133178
Consulted on 02/04/2007)
26
See Das, Satyajit, Traders, Guns & Money Knowns and Unknowns in the Dazzling World of Derivatives,
Dorchester (Financial Times Prentice Hall) 2006, Pages 282 - 284
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