Credit Derivatives

1. Energy Finance and Credit Summit 2004 Risk Limited, Sungard and Deloitte (Sponsors) Four Seasons Hotel, Houston, Texas Friday, February 27, 2004 Leslie K. McNew Clinical Professor, Finance and Director of the Trading Center AB Freeman School of Business, Tulane University, New Orleans 504-865-5036 Lmcnew@tulane.edu Credit Derivatives

2. Growth in Credit Derivatives Market End 2001: $1.2 Trillion End 2002: $1.5 Trillion 1996 1997 1998 1999 2000 1

3. Growth in Credit Derivatives Market • Credit Derivatives • Newest of the derivative markets • Developed around 1992-1993 • Used to manage and exploit risks/opportunities in credit markets • Risk transferred among participants----off or on balance sheet transactions 2

4. Growth in Credit Derivatives Market • London is the dominant financial center • Size of the international debt market • A market-friendly regulatory environment • Liquid asset swap market • Derivative strengths 3

5. Definitions Credit Derivative: a credit derivative allows the holder to isolate and separate credit risk from market risk, thus allowing this credit risk to be either hedged, traded, or transferred. A premium may be due. Credit Default Swap: enables isolation and transfer of credit risk without transferring ownership of the asset Digital Derivative: cash settled transaction (does not need delivery of underlying asset upon settlement) Total Return Swap: transfer credit risk by swapping an underlying asset’s specified total return (capital growth and interest) between two counterparties, in return for regular payments of LIBOR + spread LIBOR: the London inter-bank offer rate. The inter-bank rate used when one bank borrows from another. It is also the benchmark used to price many capital market and derivative transactions. Credit Spread: difference in ‘yields’ between an agreed reference rate and a specific asset in question. London: gilt market US: treasury market Off-balance sheet: instrument or trade does not have to be admitted to the firm’s balance sheet (can be ‘hidden’) 4

6. Credit Derivative ‘Trigger’ Events • Payment default or bankruptcy/insolvency in the case of corporate credits • Moratorium on payments or the rescheduling of payments, as well as payment default • itself, for sovereign credits • Chapter 11 or bankruptcy filing by the issuer • failure to meet payment obligations when due • rating downgrade below an agreed upon level • change in the agreed credit spread (over a government bond or compared to another • government bond) • A materiality threshold (a significant price decline) has also to be breached and independently agreed. 5

7. Fee Determinants for Credit Derivatives • credit rating or probable swap counterparty • maturity • probability of default • expected value of the asset (post-default) Prices from around the time of the California energy crisis Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005 6

8. Why Use Credit Derivatives? Protection Buyer • 4 Main Reasons • Reduce exposure to a company or bank whose credit rating is deteriorating • To free up credit lines so that higher margin businesses may be transacted • To protect against a downgrading below a portfolio manager’s internal limits • To reduce credit exposures which have exceeded limits, possibly where interest rates or currency movements have exceeded expectations 7

9. Investment Bank Credit Default Swap: in Energy Market • Energy Company has a large exposure to Duke due to trading activities • Energy Company wishes to reduce default risk to Duke • Energy Company buys credit derivative from Investment Bank to reduce (‘insure’) Duke credit risk exposure: purchases a DITIGAL instrument • Investment Bank only pays out notional amount to Energy Company if Duke experiences a default event (see “Triggers”) $ Energy Company Energy Company pays 82 basis points to receive, within 1 year, $10 M from the Investment Bank if Duke Energy defaults Receive $ notional amount of credit protection If Duke defaults within one year, the Energy company owns default ‘insurance’ that will pay $10 M regardless of the amount of the Duke default 10

10. Total Return of Asset Total Return Payer (X) Total Return Receiver (Y) LIBOR + spread Total Return Swap Instead of lump sum notional payment in the event of default, the protection buyer receives a specified economic value for the reference credit. Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protection Total Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protection Reference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure Reference Asset • Energy Company (X) pays any appreciation on the capital value of the underlying asset as well as any coupons receivable • Investment Bank (Y) pays Energy Company (X) any depreciation of the capital value as well as a LIBOR linked floating margin • Energy Company (X) is guaranteed a specified capital value for the underlying, as well as a LIBOR linked income for the duration of the swap • Investment Bank (Y) ‘owns’ the credit risk, as well as any income and any profits generated by this asset • Energy Company (X) retains the ownership of the reference asset, and must continue to fund the asset (reference asset) • If there is no credit event, there will be no contingent payment 11

11. Total Return of Asset Total Return Payer (X) Total Return Receiver (Y) Reference Asset LIBOR + spread Total Return Swap Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protection Total Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protection Reference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure • Why Use Total Return Swaps? • lock in a specified economic value for the duration of the swap • transfer the market risk of an asset off-balance sheet to lower regulatory charges • used for trading credits on a leverage off-balance sheet basis 12

12. Credit Spreads Credit Spread: difference in ‘yields’ between an agreed reference rate and a specific asset in question. London: gilt market US: treasury market • Example: • T0 Corporate bond trades at 55 basis points over gilt • T1 Corporate bond now trades at 45 basis points over gilt • the credit spread has ‘narrowed’ (‘tightened’) • credit quality of bond/bond issuer has improved • WIDER CREDIT SPREADS IMPLY MORE LIKELY • CHANCE OF DEFAULT 13

13. Credit Spreads 2 Distinct Versions: Credit spread relative to benchmark Credit spread between two ‘credit-sensitive’ assets Easiest way to enter transaction is through OPTIONS Credit spread options enable trading/hedging of changes in credit quality of the specified reference credit Strike set at a particular credit spread 14

14. Credit Spread Options Payoff: C[spread(T);(K)] = (spread(T) – K) x notional amount x risk factor Where Spread(T) = the spread for the financial asset over the risk-less rate at the maturity of the option K = the specified strike spread Notional amount = a contractually specified dollar amount equal to the amount that needs to be hedged Risk Factor = based on measures of duration and convexity For a description of duration, convexity and other financial calculations, purchase ‘Mastering Financial Calculations,’ Robert Steiner, Financial Times/Pitman Publishing, 1998, refer to chapter 5 for bond market calculations, and chapter 9 for options 15

15. Credit Spread Options • Energy Company X is concerned about a ‘credit downgrade’ of one of its counterparties • Current counterparty is trading “A” rating, Energy Company X is concerned it will be downgraded to a “B” • Energy Company X buys ‘downgrade’ protection in the form of a credit spread option • If the credit spread on its counterparties widens, downgrade from “A” to “B”, Energy Company X receives a payout • Energy Company X buys a call option on the credit spread (widening spread) and pays a premium In basis points In basis points Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005 16

16. Payment of premium Breakeven Credit spread has widened from 150 bps to 300 bps after 1 year, and option pays out Credit Spread Options Option payout = change in credit spread x notional amount x risk factor Option payout = [(300-150)/10,000] x $1,000 x 1.867 = $28.00 17

17. Energy Company X Investment Bank First to Default Basket Options: Notional Payout Just as a portfolio manager may purchase protection on a single name (credit), said manager may also purchase protection on a basket of names (credits): two or more. In the case of the FIRST TO DEFAULT STRUCTURE, the credits in the ‘basket’ are protected against default for a set notional amount. The risk credit to default triggers the basket payout and basket termination. At this point, the other credits are left un-hedged, and most be re-hedged. FIRST TO DEFAULT BASKET $ Duke Energy Corp American Electric Power Sempra Energy Reliant Energy Inc El Paso Electric Co Southern Co Dynegy Inc NexCollateral receives $10 M if ONE of the basket’s participants defaults $10 M Notional Total FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance 18

18. First to Default Baskets vs. Straight Credit Default Derivatives COST SAVINGS FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance 19

19. PRACTICAL EXAMPLES APPENDIX E - CREDIT RISK LIMITS Table 1: Portfolio Mix Limits, secured by parental guarantees Maximum % of Actual Policy of Midwestern Utility Outstanding Exposure ** Rating Max. Tenor By Rating Category AAA 3 years N/A AA 3 Years N/A A 3 Years 50% (1) BBB 2 Years 30% Collateral (security) comes in different formats: · Cash · Securities · Treasuries Can be converted to cash in case of default · Surety Bonds · Letters of Credit · Parental Guarantees Promise made on behalf of parent to secure activity undertaken by subsidiary, to a specific entity (contractual form). At current time, promise only secures the pre settlement and settlement risk of actual transactions, no VaR or liquidated damages. Specific entity usually must seek legal recourse to recover against this form of collateral in the case of default. In Energy industry, large percentage of trading partners rated BBB or less, and the convention is to secure transactions with parental guarantees 20

20. PRACTICAL EXAMPLES Apply Credit Derivatives to Policy Objectives APPENDIX E - CREDIT RISK LIMITS Table 1: Portfolio Mix Limits, secured by parental guarantees Maximum % of Actual Policy of Midwestern Utility Outstanding Exposure ** Rating Max. Tenor By Rating Category AAA 3 years N/A AA 3 Years N/A A 3 Years 50% (1) BBB 2 Years 30% • Problem: • 1. Corporate does not want to have significant portfolio exposure • to BBB risk • Corporate does not want to have significant portfolio exposure • to parental guarantees as security • Energy industry, as practice, transacts on parental guarantees • Energy industry participants heavily weighted toward BBB • Need large liquid pool from which to transact to make $$$$ 21

21. PRACTICAL EXAMPLES Apply Credit Derivatives to Policy Objectives APPENDIX E - CREDIT RISK LIMITS Table 1: Portfolio Mix Limits, secured by parental guarantees Maximum % of Actual Policy of Midwestern Utility Outstanding Exposure ** Rating Max. Tenor By Rating Category AAA 3 years N/A AA 3 Years N/A A 3 Years 50% (1) BBB 2 Years 30% Answer: Secure all BBB parental guarantee participants beyond 30% threshold with credit derivatives Mitigate the portfolio credit risk by buying protection 22

22. PRACTICAL EXAMPLES Apply Credit Derivatives to Policy Objectives • Individual Counterparty Hedge: • Set traditional credit limit • Purchase protection in form of default credit derivative against credit limit (limit and notional amount must match) • Mitigate all credit exposure to counterparty by above off-balance sheet transaction (transferred risk to AA rated investment bank --- always risk that said bank will default) • Monitor available credit such that it does not exceed credit limit • Charge traders or profit center for cost of credit derivative • 100% compliance with policy while still allowing trading liquidity 23

23. PRACTICAL EXAMPLES Counterparties Over Credit Limit • Problem/Resolution: • Traders/marketers put deal in system that breaches credit limits • Discipline action required (see policy) • Company now exposed to greater risk than desired • Purchase default derivative to cover risk until situation can be resolved • Charge person/group responsible for cost of protection (against their P/L) 24

24. PRACTICAL EXAMPLES Credit in High Volatility Months Example, summer is high volatility for power. Keep the deals on the book, get paid for the extra risk that the company is taking. 25

25. Total Return of Asset Energy Company (X) Investment Bank (Y) Dynegy LIBOR + spread PRACTICAL EXAMPLES Credit in High Volatility Months Total Return Swap lock in a specified economic value for the duration of the swap • Energy Company X will raise credit limits during high vol months • Energy Company X takes on more risk during this period and wishes to be compensated for said risk • Total return swap pays Energy Company X a rate equal to LIBOR + spread, and any depreciation on asset (Dynegy) • Energy Company X pays investment bank any appreciation on asset (Dynegy) • Energy Company X earns a higher rate of return during the swap, which compensates it for the increased risk that it is assuming 26

26. PRACTICAL EXAMPLES • Problem • Rumors in energy industry indicate that problems are brewing in California market (possibility of credit defaults) • Energy company X has large position due to trading transactions with PG&E • Energy company X wants a credit hedge to offset against any cash flow problems PG&E may incur (credit manager is hearing rumors, and wants some protection, but not costly protection • Energy company X credit manager buys credit spread call (credit widening---possibility of default greater), struck at current spread level, on PG&E • Energy company X credit manager buys call against current mark to market position (notional amount of call equals current mark to market credit risk position with PG&E) 27

27. PRACTICAL EXAMPLES Credit Spreads Against Credit Migration Downward Current credit spread is 72 bps., and credit manager sets notional amount at $10 M. Credit spread widens to 600 bps after 6 months, and the option pays out over $3 M. If the credit manager had been wrong on acting on the rumor, the cost of the option would have been minimal. As it was, the credit manager acted, and although PG&E did not default, the spread widen to compensate the credit manager for the extra risk her portfolio had taken to transact with PG&E Credit spread has widened from 72 bps to 600 bps after 6 months, and Energy Company X gets out of option Payment of premium Breakeven 28

28. Optimal Credit Protection Column Parental Guarantees Payoff based on recovery percentage Credit Derivatives All of payoff in event of default situation Letters of Credit Credit Portfolio Insurance 29

29. Type in stock ticker (AEP) After stock ticker, space, type “CORP” GO Select Corporate Bond desired for analysis Using Bloomberg Example of a List of Corporate Bonds 30

30. Select Corporate Bond Then, when inside bond, ASW GO Using Bloomberg corporation 31 Good way to get an estimation, actual quotes differ by 20-50 bps.

31. Using Bloomberg 32