1 / 25

Financial Risk Management

Financial Risk Management. Zvi Wiener Following P. Jorion, Financial Risk Manager Handbook. Chapter 22 Credit Derivatives. Following P. Jorion 2001 Financial Risk Manager Handbook. Credit Derivatives. From 1996 to 2000 the market has grown from $40B to $810B

octavia-barnett
Download Presentation

Financial Risk Management

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Financial Risk Management Zvi Wiener Following P. Jorion,Financial Risk Manager Handbook FRM

  2. Chapter 22Credit Derivatives Following P. Jorion 2001 Financial Risk Manager Handbook FRM

  3. Credit Derivatives From 1996 to 2000 the market has grown from $40B to $810B Contracts that pass credit risk from one counterparty to another. Allow separation of credit from other exposures. Zvi Wiener

  4. Credit Derivatives Bond insurance Letter of credit Credit derivatives on organized exchanges: TED spread = Treasury-Eurodollar spread (Futures are driven by AA type rates). Zvi Wiener

  5. Types of Credit Derivatives Underlying credit (single or a group of entities) Exercise conditions (credit event, rating, spread) Payoff function (fixed, linear, non-linear) Zvi Wiener

  6. Types of Credit Derivatives November 1, 2000 reported by Risk Credit default swaps 45% Synthetic securitization 26% Asset swaps 12% Credit-linked notes 9% Basket default swaps 5% Credit spread options 3% Zvi Wiener

  7. premium Contingent payment Credit Default Swap A buyer (A) pays a premium (single or periodic payments) to a seller (B) but if a credit event occurs the seller (B) will compensate the buyer. B - seller A - buyer Reference asset Zvi Wiener

  8. Example • The protection buyer (A) enters a 1-year credit default swap on a notional of $100M worth of 10-year bond issued by XYZ. Annual payment is 50 bp. • At the beginning of the year A pays $500,000 to the seller. • Assume there is a default of XYZ bond by the end of the year. Now the bond is traded at 40 cents on dollar. • The protection seller will compensate A by $60M. Zvi Wiener

  9. Types of Settlement Lump-sum – fixed payment if a trigger event occurs Cash settlement – payment = strike – market value Physical delivery – you get the full price in exchange of the defaulted obligation. Basket of bonds, partial compensation, etc. Zvi Wiener

  10. Total Return Swap (TRS) Protection buyer (A) makes a series of payments linked to the total return on a reference asset. In exchange the protection seller makes a series of payments tied to a reference rate (Libor or Treasury plus a spread). Zvi Wiener

  11. Payment tied to reference asset Payment tied to reference rate Total Return Swap (TRS) B - seller A - buyer Reference asset Zvi Wiener

  12. Example TRS • Bank A made a $100M loan to company XYZ at a fixed rate of 10%. The bank can hedge the exposure to XYZ by entering TRS with counterparty B. The bank promises to pay the interest on the loan plus the change in market value of the loan in exchange for LIBOR + 50 bp. • Assume that LIBOR=9% and by the end of the year the value of the bond drops from $100 to $95M. • The bank has to pay $10M-$5M=5M and will receive in exchange $9+$0.5M=9.5M Zvi Wiener

  13. Credit Spread Forward Payment = (S-F)*Duration*Notional S – actual spread F – agreed upon spread Cash settlement May require credit line of collateral Zvi Wiener

  14. Credit Spread Option Put type Payment = Max(S-K, 0)*Duration*Notional Call type Payment = Max(K-S, 0)*Duration*Notional Zvi Wiener

  15. Example A credit spread option has a notional of $100M with a maturity of one year. The underlying security is a 8% 10-year bond issued by corporation XYZ. The current spread is 150bp against 10-year Treasuries. The option is European type with a strike of 160bp. Assume that at expiration Treasury yield has moved from 6.5% to 6% and the credit spread widened to 180bp. The price of an 8% coupon 9-year semi-annual bond discounted at 6+1.8=7.8% is $101.276. The price of the same bond discounted at 6+1.6=7.6% is $102.574. The payout is (102.574-101.276)/100*$100M = $1,297,237 Zvi Wiener

  16. Credit Linked Notes (CLN) Combine a regular coupon-paying note with some credit risk feature. The goal is to increase the yield to the investor in exchange for taking some credit risk. Zvi Wiener

  17. CLN A buys a CLN, B invests the money in a high-rated investment and makes a short position in a credit default swap. The investment yields LIBOR+Ybp, the short position allows to increase the yield by Xbp, thus the investor gets LIBOR+Y+X. Zvi Wiener

  18. par Xbp L+X+Y Contingent payment Contingent payment par LIBOR+Y Credit Linked Note CLN = AAA note + Credit swap Credit swap buyer investor AAA asset Asset backed securities can be very dangerous! Zvi Wiener

  19. Types of Credit Linked Note Type Maximal Loss Asset-backed Initial investment Compound Credit Amount from the first default Principal Protection Interest Enhanced Asset Return Pre-determined Zvi Wiener

  20. FRM 2000-39 Credit Risk (22-5) A portfolio consists of one (long) $100M asset and a default protection contract on this asset. The probability of default over the next year is 10% for the asset, 20% for the counterparty that wrote the default protection. The joint probability of default is 3%. Estimate the expected loss on this portfolio due to credit defaults over the next year assuming 40% recovery rate on the asset and 0% recovery rate for the counterparty. A. $3.0M B. $2.2M C. $1.8M D. None of the above Zvi Wiener

  21. FRM 2000-39 Credit Risk A portfolio consists of one (long) $100M asset and a default protection contract on this asset. The probability of default over the next year is 10% for the asset, 20% for the counterparty that wrote the default protection. The joint probability of default is 3%. Estimate the expected loss on this portfolio due to credit defaults over the next year assuming 40% recovery rate on the asset and 0% recovery rate for the counterparty. A. $3.0M B. $2.2M C. $1.8M = $100*0.03*(1– 40%) only joint default leads to a loss D. None of the above Zvi Wiener

  22. FRM 2000-62 Credit Risk (22-11) Bank made a $200M loan at 12%. The bank wants to hedge the exposure by entering a TRS with a counterparty. The bank promises to pay the interest on the loan plus the change in market value in exchange for LIBOR+40bp. If after one year the market value of the loan decreased by 3% and LIBOR is 11% what is the net obligation of the bank? A. Net receipt of $4.8M B. Net payment of $4.8M C. Net receipt of $5.2M D. Net payment of $5.2M Zvi Wiener

  23. FRM 2000-62 Credit Risk (22-11) Bank made a $200M loan at 12%. The bank wants to hedge the exposure by entering a TRS with a counterparty. The bank promises to pay the interest on the loan plus the change in market value in exchange for LIBOR+40bp. If after one year the market value of the loan decreased by 3% and LIBOR is 11% what is the net obligation of the bank? A. Net receipt of $4.8M = [(12%-3%) –(11%+0.4%)]*$200M B. Net payment of $4.8M C. Net receipt of $5.2M D. Net payment of $5.2M Zvi Wiener

  24. Pricing and Hedging Credit Derivatives Zvi Wiener

  25. Example:Credit Default Swap Zvi Wiener

More Related