Credit and Weather Derivatives

Liyan DizonMarose MonederoMacky Villagarcia

Feb 11, 2011

Credit Derivatives

What are credit derivatives? General term used to describe various swap

and option contracts designed to transfer credit risk on loans or other assets from one party (protection buyer), to another party (protection seller).

The protection seller receives premium or interest-related payments in return for contracting to make payments to the protection buyers, which are linked to the credit standing of a reference asset.

What are credit derivatives?

These are derivative instruments that seek to trade in credit risks.

CREDIT RISK - The risk that a counterparty to a financial transaction will fail to fulfill their obligation

Growth in Credit Derivatives Source: British Bankers Association Credit Derivatives Report

Credit Derivatives Market Participants Source: British Bankers Association (BBA)

Sel l ers

Secur i t i es Fi rms BanksGovernment Pensi on FundsMutual Funds I nsures/ Rei nsurersCorporates Hedge Funds

Types of Credit Derivatives

Credit Default Swaps Credit Spread Option Credit Linked Note

1. Credit Default Swap

Allow one party to buy protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

The protection buyer pays a premium for the protection, and the protection seller agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified credit events.

What is a credit event? Any sudden and tangible (negative) change in

a borrower's credit standing or decline in credit rating. A credit event brings into question the borrower's ability to repay its debt.

Credit events include bankruptcies or violating a bond indenture or other loan agreement.

Example…

Suppose Bank A buys a bond which issued by a Steel Company.

To hedge the default of Steel Company, it enters into a credit derivative deal with Insurance Company C.

Bank A buys a credit default swap from Insurance Company C.

Bank A pays fixed periodic payments to C, in exchange for default protection.

Exhibit Credit Default Swap

Bank A

Buyer

Insurance Company C

Seller

Steel company

Reference Asset

Contingent Payment On

Credit Event

Premium Fee

Credit Risk

2. Credit Spread Option

Grants the buyer the right, but not the obligation, to purchase a bond during a specified future “exercise” period at the contemporaneous market price and to receive an amount equal to the price implied by a “strike spread” stated in the contract

CREDIT SPREAD – the difference between the yield on the borrower’s debt (loan or bond) and the yield on the referenced benchmark of the same maturity

Example…

An investor may purchase from an insurer an option to sell a bond at a particular spread above LIBOR Credit spread.

If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse.

Example…

3. Credit Linked Notes

Is essentially a funded credit default swap which transfers credit risk from the note issuer to the investor.

The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.

If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.

Example…Refer to the Steel company case again

Bank A would extend a $1 million loan to the Steel Company.

At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.

If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.

Exhibit

Bank A Institutional investors

Steel Company

$1 Million

fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate

$1millio

n

500b p

Steel

Company

Weather Derivatives

Sources

http://www.credit-deriv.com/introduction%20to%20credit%20derivatives%20article%20by%20Vinod%20Kothari.pdf

http://www.investopedia.com/terms/c/creditderivative.asp

Credit and Weather Derivatives

Liyan DizonMarose MonederoMacky Villagarcia

Feb 11, 2011