Credit Derivatives Pricing and Applications

1. Credit Derivatives Pricing and Applications

2. Credit Default Swaps

3. Global OTC Derivatives Market

4. FX Derivatives

5. Interest Rate Derivatives

6. CDS Notional and Gross Market value

7. Notional V Gross Market Value • Notional amounts outstanding provide a measure of market size and a reference from which contractual payments are determined in derivatives markets. However, such amounts are not truly at risk. The amounts at risk in derivatives contracts are a function of the • Price level and/or volatility of the financial reference index used in the determination of contract payments, • The duration and liquidity of contracts, and the creditworthiness of counterparties. • They are also a function of whether an exchange of notional principal takes place between counterparties. • Gross market values provide a more accurate measure of the scale of financial risk as a measure of cost of replacing the contract. • The term “gross” is used to indicate that contracts with positive and negative replacement values with the same counterparty are not netted.

8. Credit Derivative Products • Credit default swap • Credit linked Noted • CLOs • Total return swap • Credit spread forward • Credit spread Option

9. Credit Spread • The spread of default-free bond with that of the defaultable debt instruments provides valuable information in the following ways. • -Conveys Probability of default • -As a leading economic indicators • -As an efficient allocator

10. Implication of spread • Using the spread the Central Banks analyze the interdependence between: • The Treasury bonds, corporate bonds and money market debt to gain insight into responses to monetary policy changes. • For example, widening or tightening spread is the credit market response to ration credits to the less credit (good credit) worthy issuer.

11. Application of Credit Derivatives • Credit derivatives enable the parties to reduce credit exposure without physically removing assets from the balance sheet. • However, transaction on credit derivatives is confidential and does not require notification of the customer thereby separating fiduciary relationship with that of the risk management decisions.

12. Credit Event/Default Swap • This is an over the counter contract between two parties, where party A the buyer of the protection pays an annuity (insurance premium) to the party B, the seller of the protection on the risky debt instrument “reference asset” issued by party C. • Protection seller (Party B) is obligated to pay the face value of the reference asset/assets triggered by the events as outlined in the ISDA master agreement contract. • Uncorrelated conterparty

13. Max [Par(1-R)!ISAD events, 0]

15. Triggered Events • The credit event(s) that obligates the seller of the CDS to pay the buyer may include some or all of the followings: • - Bankruptcy • -Counterparty failure to pay • -Material restructuring debt • -Capital control/moratorium • -Obligation acceleration or default • -Downgrade • Receivership

16. Pricing CDS • The price of CDS can be estimated as a portfolio of long position at: • the frn at LIBOR + q bps plus a long position on the CDS on the same bond at the cost of z bps to produce a synthetic default free frn as follows. Long frn+ long CDS=synthetic risk free frn Suppose the bid/offer spread is 1/8 on the LIBID/LIBOR, and TED is 12.5 basis points resulting at a default swap spread of z as follows: • LIBOR + q – z = LIBID - TED • LIBOR – LIBID = z-q- TED • z = q +25 bps z = 175 bps

17. Credit Default Swap Quotation (A1/A) Term Bid Offer Ref obligation XYZ 7.125% 1/31/ 10 • 5 yrs 55 65 • Payout/Settlement • Physical, Par Versus • Delivery, January 31, 2001

18. Probability of Default • Pdf = Pd + long put Where Pdf and Pd are default-free and risky defaultable debt. • PD = [1- (Pd / Pdf )] (1- R) PD = [1-(75.08/78.35)] (1- R) = .041

19. Rating from: Aaa Aa A Baa Ba B Caa-C Default WR Aaa 88.32% 6.15% 0.99% 0.23% 0.02% 0.00% 0.00% 0.00% 4.29% Aa 1.21% 86.76% 5.76% 0.66% 0.16% 0.02% 0.00% 0.06% 5.36% A 0.07% 2.30% 86.09% 4.67% 0.63% 0.10% 0.02% 0.12% 5.99% Baa 0.03% 0.24% 3.87% 82.52% 4.68% 0.61% 0.06% 0.28% 7.71% Ba 0.01% 0.08% 0.39% 4.61% 79.03% 4.96% 0.41% 1.11% 9.39% B 0.00% 0.04% 0.13% 0.60% 5.79% 76.33% 3.08% 3.49% 10.53% Caa-C 0.00% 0.02% 0.04% 0.34% 1.26% 5.29% 71.87% 12.41% 8.78% : Moody’s Average 1-year credit ratings transition matrix, 1920-1996.

20. Average Recovery Rates on U.S. Corporate Bonds Class Mean(%) Standard Deviation Senior Secured 52.31 25.15 Senior Unsecured 48.84 25.01 Senior Subordinated 39.46 24.59 Subordinated 33.17 20.78 Junior Subordinated 19.69 13.85

21. Argentina Sovereign Spread Fixed-Rate Coupon Maturity Time to Maturity Bid Price Yield to Maturity U.S. Tsy Yield Spread 10.950% Nov. 99 1.03yr. 94.50 16.99% 4.03% 12.96 9.250 Feb. 01 2.34 96.00 11.23 4.08 7.15 8.375 Dec. 03 5.16 93.00 10.14 4.21 5.16 11.000 Oct. 06 7.97 96.50 11.69 4.51 7.97 Time to Expiration Sell Default Protection Buy Default Protection 3 years 9.00% 10.00% • 8.00 9.00 10 7.50 8.00

22. Synthetic structure Pdf - Pd = long put (long CDS) Example: Buying December 03 bond and buying protection produces return of (10.14 minus 9%). This return is 3.07 percent less than the return in a default free Treasury bond yielding 4.21%. • Sell February 01 and buy the U.S. treasury yielding 4.08 percent and selling 3-year default swap for 9 percent. This scenario produces total return from the synthetic long bond of 13.08 percent (4.08 percent plus 9 percent for selling CDS) as compared to the cash market yield of 11.23 percent picking up 185 basispoints more in the synthetic structure.

23. Pd = Pdf - long put • -long put = short put • Investors can write default swap (sell protection), by posting required margin and simultaneously buying risk-free instrument Pdf. The synthetic risky asset created usually has a higher yield than the yield on the cash market instrument.

24. Credit Default Swap Applications • Banks with credit exposure to corporate or sovereign bonds can be able to mitigate their risk through: • Purchasing credit default protection • Sell the loan in the secondary market • Banks who are willing to reduce concentration risk • Sell default protection • Buy a bond issued by an obligor to which they wish to have exposure • Lend money to an obligor to which they wish to have an exposure • Buy Credit-linked notes

25. Buyers of the default protections are: •  Commercial Banks • Non-financial corporations •  Actively managed debt funds •  Hedge funds Sellers of default protections are: • Life insurance companies • Reinsurance companies • Major banks • Collateralized debt obligations • Commercial paper conduits

26. Recovery Rate

29. Benefits of the structuring CLO • A bank through CLO transaction can reduce its liabilities; improve on its higher rated lower yielding assets thereby increasing return on assets and return on equity. • Reduce concentration risk: CLO enables a bank to transfer its credit exposure to a particular borrower and a particular industry to the capital market fairly efficiently. The bank in the process of securitization assumes other credit risk to which it wishes to have greater exposure. • A bank can be able to manage its liquidity, credit spread, and concentration of assets tied to floating rate index such as LIBOR through its CLO transaction thereby improving asset/liability management. • Preserving bank-clientele relationship as the CLO enables the bank to sell its loan without damaging relationship with its customer, since the sponsor and the portfolio manager of the SPV trust is the affiliate of the bank and there is no need to notify the client in selling or assigning of the loans as is the case in selling loan in a whole loan basis.

30. Synthetic CLO • Synthetic CLO emulates the cash CLO by transferring credit risk of the reference assets to the capital market through credit derivatives such as total return swap, credit default swap, or through issuing credit-linked notes without actually transferring the ownership of the assets to the bankruptcy-remote SPV trust.

31. Motivations for structuring synthetic CLO/CBO • Regulatory Capital relief • Risk transfer • Arbitrage profit • Restructuring balance sheet

33. Types of Synthetic CLO • There are two, arbitrage and balance sheet. • The arbitrage CLO, usually undertaken by insurance companies, asset management, and investment banking firms to exploits yield miss-match (spread) on the underlying pool of assets and the lower cost of servicing CLO liabilities. • The balance sheet CLOs are employed by banks to mitigate and manage regulatory and risk-based capital.

34. Risk Weighting • The cash CLO on corporate exposure is 100 percent risk-weighted, while for synthetic CLOs, the risk-weighting is much less, reflecting the funded portion of the structure that is backed by government securities that is zero risk-weighted. • The above phenomena has prompted European banks to issue synthetic CLO by taking advantage of the fact that capital adequacy requirements (8 percent minimum capital on corporate exposure) do not differentiate between various levels of operating, market and credit risks.

36. BIS capital requirements The BIS capital requirements for various classes of debts for on-balance sheet requirements are as follows: • The sovereign government debt of the member of Organization of Economic Cooperation and Development (OECD) is assigned zero BIS risk weight, these debts are treated as risk free and banks are not required to hold any reserve capital against them. • The senior debts of the banks from OECD are assigned 20 percent BIS risk weight; the banks are required to hold 1.6 percent (.20 x.08) of reserve capital for this type of debts. For example, a bank has to hold $320,000 in reserve capital (.20 x .08 x $200,000,000) for $200 million investment in a Mexican bank note. • Unfunded corporate revolving credits is assigned a 50 percent risk weight, the bank is required to hold a 4 percent (.50 x .08) reserve capital. • For all others, including corporate debts, funded revolving credit, non-OECD sovereign debts 100 percent BIS risk weight is assigned, requiring financial institutions to hold 8 percent reserve capital against the risk based assets.

38. Total Return Swaps • TRS are HLT that motivate the receiver to take on the credit risk of an asset it does not own. • The bank who wishes to layoff the risk to the reference asset has high concentration risk. • The bank motivations may include: • Reducing exposure without selling the asset • Preserving banking relationship with the client • Realizing regulatory capital relief • Managing balance sheet to originate

39. LIBOR+300 bps+ MV Hedge Fund Seller of protection Bank Buyer of protection LIBOR + 75 bps Total Return Swap: Example • A Bank enters into a TRS with a hedge fund on the reference credit rated BBB to layoff credit risk, with the notional principal of $50 million. The bank agrees to pay LIBOR+300bps+MV and receives LIBOR + 75 bps.

40. Motivations of the Receiver of TRS • The receiver is likely to have a host of reasons to enter into this HLT, for example: • Financing huge transaction with limited capital • Exploiting the leverage as the return/risk can be magnified • Arbitrage profit albeit risky • Access to capital market not previously available • Sectoral arbitrage of credit risk in the high yield market