Credit Derivatives

1. Credit Derivatives Chapter 29

2. Credit Derivatives • credit risk in non-Treasury securities • developed derivative securities that provide protection against credit risk • types • asset swaps • total return swaps • credit default swaps • credit spread options • credit spread forwards • structured credit products • synthetic CDOs • credit-linked notes

3. Credit Derivatives • types of credit risk • default risk • credit spread risk • downgrade risk • categories of credit derivatives

4. Credit Derivative Terminology • reference entity (reference issuer) • reference obligation (reference asset) • credit event • bankruptcy • credit event upon merger • cross acceleration • cross default • downgrade • failure to pay • repudiation/moratorium • restructuring

5. Asset Swaps • example • investor purchases $10m par of 7.85%, 5 year bond of BBB-rated firm at par with semiannual coupons • investor enters into 5 year swap where he is fixed rate payer with semiannual payments – pays 7.0% and gets 6 month LIBOR • investor earns 85bp over LIBOR if no default • investor has created synthetic floating-rate bond

6. Total Return Swap • swap where one party makes periodic floating-rate payments to counterparty in exchange for the total return realized on a reference obligation • total return index swap • total return receiver – exposed to credit and interest rate risk • total return payer

7. Total Return Swap Example • portfolio manager thinks Izzo’s fortunes will improve and credit spread relative to Treasury will decline over next year • used to increase exposure to reference obligation • Izzo issued 10 year bond at par with 9% coupon when Treasury is 6.2% - credit spread to Treasury? • what can manager do if she believes spread declines? • total return swap as receiver with reference obligation of Izzo bond issue – semiannual payments – receiver pays 6 month Treasury + 160bp – notional $10m • over one year • 6 month Treasury starts at 4.8% • rate for computing second semiannual payment is 5.4% • at the end of year 1, 9 year Treasury rate is 7.6% • at the end of year 1, credit spread for reference obligation is 180bp

8. Total Return Swap Example • first swap payment is 3.2% (4.8% + 160bp divided by 2) * notional • second swap payment is 3.5% (5.4% + 160bp divided by 2) * notional • payments received by manager are coupon payment (9%*10m) and change in value of reference obligation which will sell to yield (7.6% + 180=9.4%) - find price of this bond portfolio manager must make payment of $9,000

9. Total Return Swaps • benefits • receiver does not have to finance purchase of reference assets • receiver can get same economic exposure to diversified basket of assets in one swap transaction that would otherwise take several cash market transactions • investor can use total return swap to short a corporate bond – action that is otherwise difficult • disadvantage • return to receiver is dependent on both credit risk (declining or increasing credit spreads) and market risk (declining or increasing market rates) • credit-independent market risk • credit-dependent market risk

10. Credit Default Swaps • most commonly used stand-alone product of group • simplest form so others (credit default options) rarely used • used to shift credit exposure to a credit protection seller • purpose is to hedge credit exposure to a specific asset or issuer • single name credit default swap • basket credit default swap • credit default swap index • buyer pays fee to protection seller in return for right to receive payment conditional upon occurrence of credit event by reference obligation or reference entity • protection seller must pay if credit event occurs

11. Credit Default Swaps • interdealer market for single-name credit default swaps • swaps for corporate and sovereign entities are standardized • some custom agreements • typically 5 years • settlement • cash or physical delivery • payment by protection seller – predetermined or based on change in value of reference obligation • amount of payment can be set or may be determined after credit event

12. Single-Name Credit Default Swaps • reference entity is XYZ Corp. and underlying is $10m par of XYZ bonds • swap premium is 200bp – calls for quarterly payment of premium • quarterly payment determined using day count convention of actual/360 • assume there are 92 days in quarter and premium is 200bp on $10m • if no credit event, protection buyer makes quarterly payments over life of swap – if credit event occurs: • no more payments of swap premium by protection buyer to seller • termination value is determined for swap – with physical settlement there are issues called deliverable obligations

13. Single-Name Credit Default Swaps

14. Single-Name Credit Default Swaps • uses by portfolio managers: • obtain exposure to reference entity using swap market instead of cash market because more liquid • do this by selling protection and receiving a swap premium • difficult to sell currently held bond that has credit concern • buy protection in swap market • if manager believes issuer will soon have trouble, shorting bond would be best but hard to short bond • enter into swap as protection buyer • manager who wants a leveraged position in a corporate bond • economically, a position of a protection buyer is equal to leveraged position in corporate bond

15. Basket Credit Default Swaps • must specify when a payment needs to be made because they can be structured different ways • first-to-default basket swap • second-to-default basket swap • cash settlement most common

16. Credit Default Swap Index • credit risk of standardized basket of reference entities is transferred • swap premium is paid but if credit event occurs, the swap premium payment continues but amount of payment is reduced (because notional amount of reference entity is reduced) • uses by portfolio manager • help adjust exposure to a credit sector of bond market index • increase exposure to credit sector by entering as protection seller • decrease exposure by entering as protection buyer