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Chapter 15. Credit Derivatives. BIS Capital Requirements for Credit Derivatives. Interest rate derivatives total $65 trillion FX derivatives exceed $16 trillion Equity derivatives $2 trillion As of 6/01: credit derivatives = $1 trillion.
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Chapter 15 Credit Derivatives
BIS Capital Requirements for Credit Derivatives • Interest rate derivatives total $65 trillion • FX derivatives exceed $16 trillion • Equity derivatives $2 trillion • As of 6/01: credit derivatives = $1 trillion. • Insurance cos. are net suppliers of credit risk protection. Banks and securities firms are net buyers. Figure 15.1. • BIS II proposes harmonization of treatment of credit derivatives. “w” factor adjusts risk weight. Saunders & Allen Chapter 15
Credit Spread Call Option • Payoff increases as the credit spread (CS) on a benchmark bond increases above some exercise spread ST. • Payoff on option = Modified duration x FV of option x (current CS – ST) • Basis risk if CS on benchmark bond is not closely related to borrower’s nontraded credit risk. • Figure 15.3 shows the payoff structure. Saunders & Allen Chapter 15
Default Option • Pays a stated amount in the event of default. • Usually specifies physical delivery in the event of default. • Figure 15.4 shows the payoff structure. • Variation: “barrier” option – if CS fall below some amount, then the option ceases to exist. Lowers the option premium. Saunders & Allen Chapter 15
Breakdown of Credit Derivatives: Rule (2001) British Bankers Assoc Survey • 50% of notional value are credit swaps • 23% are Collateralized Loan Obligations (CLOs) • 8% are baskets (credit derivatives based on a small portfolio of loans each listed individually. A first-to-default basket credit default swap is triggered by the default of any security in the portfolio). • 6% are credit spread options Saunders & Allen Chapter 15
The Total Return Swap • Swaps fixed loan payment plus the change in the market value of the loan for a variable rate interest payment (tied to LIBOR). • Figure 15.5 shows the structure. • Table 15.1 shows the cash flows if the fixed loan rate=12%, LIBOR=11%, and the loan depreciates 10% in value over the year (at swap maturity). Buyer of credit protection (the bank lender) receives 11% and pays out (12% - 10%) = 2% for a net cash inflow of 9%. Saunders & Allen Chapter 15
Credit Default Swaps (CDS) • CDS specifies: • Identity of reference loan • Definition of credit event (default, restructuring, etc.) • Payoff upon credit event. • Specification of physical or cash settlement. • July 1999: master agreement for CDS by ISDA • Swap premium = CS • Figure 15.6 shows the cash flows on the CDS. Saunders & Allen Chapter 15
Pricing the CDS: Promoting Price Discovery in the Debt Market • Premium on CDS = PD x LGD = CS on reference loan • Decomposition of risky debt prices to obtain PD (see chapter 5): • Basis in swap market (CDS premium CS) because: • Noise and embedded options in risky debt prices. • Liquidity premium in debt market. • Default risk premiums in CDS market for counterparty default risk. Increase as correlations increase and credit ratings deteriorate. Table 15.2. • High cost of arbitrage between CDS and debt markets. Saunders & Allen Chapter 15
Table 15.2CDS Spreads for Different Counterparties Saunders & Allen Chapter 15
Hedging Credit Risk with Credit Risk Forwards • Credit forward hedges against an increase in default risk on a loan. • Benchmark bond CSF. MD=modified duration. • Actual CST on forward maturity date. • Figure 15.8: Hedging loan default risk by selling a credit forward contract. Even if CSF > CST, then there is a maximum cash outflow since CST > 0 Saunders & Allen Chapter 15
Credit SecuritiizationsCLO, CLN, CDO Since assets remain on the balance sheet, then there is no reduction in capital requirements, except under 1/2002 regulations for securities with recourse, direct credit substitutes, and residual interests supervised by US bank regulators. Sets risk weights from 20% (for AAA and AA rated) to 200% (for BB), but no change for unrated. • High spreads in ABS market makes cost of financing high for banks. • Might need borrowers’ consent to transfer loan to a SPV. • Reputational effects: ex. In July 2001, American Express took a $1 billion charge because default rates on its CDOs were 8% rather than the expected 2%. Saunders & Allen Chapter 15
Synthetic SecuritizationBISTRO (Broad Index Secured Trust Offering) • $10 billion loan portfolio backed by $850 million: • Originating bank buys credit protection with a CDS that absorbs all credit losses after the threshold is met (eg., 1.5% so bank absorbs the first $150 million of losses). • The BISTRO SPV is securitized with $700 million in US Treasury securities. • So: holders of the BISTRO do not take credit losses unless the defaults exceed $850 million. • Can use diversified portfolio (including loan commitments, letters of credit, and trade receivables) not eligible for inclusion in CLOs, CLNs or CDOs. Saunders & Allen Chapter 15
Pricing a Credit Linked Note (CLN) • $100 million 5 year coupon CLN guarantees payment of principal at maturity, but all coupon payments end if a default event occurs. Rf = 5% and CS = 7% • PV of principal = $100/1.055 = $78.35 million. If selling at par, then PV of coupon payments = $100 – 78.35 = $21.65 million. Saunders & Allen Chapter 15
Appendix 15.1 • In this replication, the investor (swap risk seller): • Purchases a cash bond with a spread of T + Sc for par • Pays fixed on a swap (T + Sc) with the maturity of the cash bond and receives LIBOR (L) • Finances the position in the repo market at a rate quoted at a spread to LIBOR (L - x) • Pledges the bond as collateral and is charged a haircut by the repo counterparty. • First 2 transactions hedge the interest rate risk. The last 2 transactions reflect the cost of financing the purchase of the risky bond. Fig. 15.10 • The credit risk exposure of the swap seller = Sc – Ss + x which is the spread between the risky bond premium and the swap spread in the fixed-floating market plus the cost of setting up the arbitrage using repos. Saunders & Allen Chapter 15
Appendix 15.2BIS II Capital Regulations for ABS • Assets can be removed from balance sheet only if there is a “clean break” such that the transferred assets are: • Legally separated from the bank, and • Placed into a SPV, and • Not under the direct or indirect control of the originating bank. • If there is “implicit recourse” then the bank may not be able to remove assets from balance sheet. • If the ABS has an early wind down provision, then the originating bank must apply a minimum 10% conversion factor. • Banks investing in ABS have risk weights ranging from 20% (AAA and AA) to 50% (A+ to A-) to 100% (BBB+ to BBB-) to 150% (BB+ to BB-) to 1250% or a 1-for-1 capital charge if ABS is rated B+ and below Saunders & Allen Chapter 15
ABS Regulatory Arbitrage under BIS I and BIS II • $100 million of BBB loans with capital charge of $8 million. • Place loans into SPV and sell 2 tranches of ABS. • Tranche 1: $80 m rated AA since only absorb default losses up to 0.3%. Sold to outside investors. • Tranche 2: Residual $20m absorb all other credit losses – rated B. Retained by bank. • Under BIS I, the bank’s capital requirement would be $20m x 8% = $1.6 m, a reduction of $6.4 million. • Under BIS II, the capital charge on the $20 million tranche would be $20 million (1-for-1), thereby eliminating any arbitrage incentives. Saunders & Allen Chapter 15
