14123 Credit Derivatives..

8/13/2019 14123 Credit Derivatives..

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Credit Risk

Credit risk is the risk of default by counterparty toa loan transaction, and is different from marketrisk.

There are ways of assessing market risk but thesame principles of its measurement cannot beapplied to measure the credit risk

o As borrowers do not pay in excess of what is

owed.

o Therefore, returns from debt cannot be regardedas having normal distribution


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Default Events

Credit derivatives are instruments that provide hedgeagainst the credit risk.

Actual defaults take place directly/ are preceded bysome events that forewarn default.

The events that signify default include downgrade of the firm debt issued by them,

bankruptcy,

Delinquency- non payment of debt when due

losses, failing economies,

movement of interest rates and exchange rates etc.


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Securitization

Loans are non-transferable and lack liquidity.

Therefore holder of these loans may convert suchnon-tradable assets into tradable ones by a

process called securitisation. Securitisation enables marketing of debt as

packaged products, to those who chase higherreturns, and in the process assume the risk of the

credit i.e. risk of default.

However, securitisation is not essential to creditderivatives.


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Credit Derivatives

We may define a credit derivative as assets

whose returns are related to credibility of the

firm as assessed by the credit rating agency.

The credit risk primarily means that the bond

would not pay the promised cash flow.

Credit derivatives are instruments intended to

cover the credit risk for a fee.


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Features-Credit Derivatives

Credit derivative enable passing the credit risk of anasset to third party.

Credit derivatives permit an investor to replicate thereturns of a financial instrument, or a portfolio of

assets, or an entity without directly engaging into theunderlying transaction of advancing.

Under credit derivative transaction the loan or theinvestment in the portfolio of credit risky assetscontinues to remain with the original investor, whilethe credit risk stands transferred to another party.

Exposure of underlying asset is not essential as is truewith derivatives.


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Probability of Default

Credit risk is difficult to measure. One way of

measurement is to find the probability of default.

Probability of default is implied in the yields the

bonds offer.

if yields on one year risk free bond and a

corporate bond were 6% and 6.50% respectively,

then the extra return of 0.50% is associated withthe default of the corporate bond over its

maturity.


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Credit Default Swaps (CDS)


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CDS is an arrangement where a protectionbuyer pays periodic premium forcompensation of potential loss from default.

The obligations of protection seller arecontingent upon happening of the defineddefault events.

Default events are the events for which theprotection seller would compensate theprotection buyer.


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Default events set a prior normally include

downgrades,

bankruptcies,

mergers,restructuring of the reference entity/obligation.

Upon occurrence of any of the default event the

premium stops. Protection seller pays the agreed amount upon

happening of default event.


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Settlement of CDS

The CDS concludes on scheduled terminationdate or the happening of the credit eventwhichever is earlier. If the period of swap ends

without credit event happening there is no cashflow. The premium too ceases.

Under cash settlement the asset remains with theprotection buyer with loss compensated by the

protection seller. Under physical settlement asset is delivered to

the protection seller for face value.


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CDS and Insurance

The payment made by the protection seller in case thedefault event occurs is called protection payment.

This is often similar to as insurance contract.

The difference in the insurance contract and the creditdefault swap is that

o Under insurance the loss must actually be incurred,and proved and paid only to that extent .

o Under CDS mere happening of the credit event issufficient cause for protection payment and the actualsuffering of loss is immaterial.


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CDS and Financial Guarantee

Credit derivatives allow hedging with thirdparty, without the reference obligationperforming any role in the transaction.

This enables creditor to transfer the credit riskwithout letting the debtor know of it.

This is a major difference between a credit

default swap and a financial guarantee asformer is bilateral while the latter is normallytrilateral.


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Total Return Swap (TRS) Under total return swap coupon as well as capital appreciation are

passed to the receiver who also assumes credit risk on the asset.

On each coupon date: Payer pays coupon, the regular return andreceives floating rate plus spread. Capital gains/loss can be

paid/received either at each payment date or at the end. On conclusion of swap: Payer pays capital gain on the value of the

asset to the receiver. This compensates for the capital gain/loss onthe reference asset by finding the difference in the market value atinception and at conclusion.

If there is default during swap period: The swap is terminated withthe loss on the reference asset due to default compensated by thereceiver to the payer.


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Total Return Swap and Interest Rate

Swap and Credit Default Swap Under interest rate swap only interest rate riskis covered and default risk is not covered.

Under CDS only default risk is covered and

interest rate risk is not. TRS covers both.

Total return swap

covers both interest rate risk and default risk.

Is a combination of IRS and CDS.


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Collateralized Debt Obligations (CDOs)

Collateralized Debt Obligations (CDOs) were

first introduced in 1988

They are essentially structured finance

product that package risk in different classes

called tranches.

Each tranche is sold to investors interested in

yield enhancement and assuming

commensurate risk.


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Each tranche has a different risk return profile

dependent upon the credit performance of the

underlying pool of asset.

The underlying pool of asset can be portfolio ofbonds or portfolio of loans. The former is called

collateralized bond obligation (CBOs) and latter is

collateralised loan obligation (CLOs). Collaterizeddebt obligations categories credit risk

and investors choose the risk return profile.


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Typical Collateralized Debt Obligation


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The payments under CDO are hierarchicalsatisfying the claims of investors dependingupon their seniority.

Interest gets precedence over principal for thenote of the same rating, and principal ofsenior notes gets precedence over the interestof lower rated notes.

Coverage tests are conducted at every stage toascertain adequacy of cash flows.

14123 Credit Derivatives..

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