FIN344: Credit Risk Management
Topic 7: Credit Derivatives and their Role in Credit Risk Management
Presented by Darren O’Connell
2
Disclaimer
• The views expressed are those of the presenter,and may not reflect those of Kaplan OHE.
•Use of information contained in this presentationis at your own risk. The presenter recommendsyou seek independent professional advice priorto making any investment decisions.
• The information in this presentation is notintended as investment advice. The presenter isnot offering or making recommendations inrelation to securities or other financial orinvestment products.
3
Subject & Topic learning outcomes
• On completion of this topic, students should be able to:
- Compare and contrast various financial instruments, in particular structured products
- Explain the credit risk implications of each of these products
- Understand the family structure of securitised assets and how they are valued
- Explain the structure of synthetic products and what advantages these offer investors and risk managers
- Discuss the market evolution of these products over the past decade
• This topic specifically addresses the following subject learning outcomes:
4. Evaluate credit derivatives and how they are used in a range of different scenarios.
5. Analyse a range of credit products.
4
1.0 Credit Derivatives
• Credit derivatives (CDs) insure and protect against adverse
movements in the credit quality of the counterparties or borrowers.
• If a borrower defaults, the investor will suffer a loss on the investment.
• With CDs, losses suffered from a default will be offset by a
corresponding gain from the CD transaction.
• CDs offer lower transactions costs, quicker payment and greater
liquidity compared to a comparable product in the insurance market.
• CDs were initially invented to hedge an offsetting position in the
physical market, but now trading includes speculators which led to
CDs being a superior product to reducing credit risk compared to
traditional insurance.
• CDs are OTC products which are privately negotiated instruments and
thus lie somewhere between traditional credit insurance products and
exchange traded derivatives.
5
Credit Derivatives (cont.)
• There are risks associated with using OTC CD contracts. These
include:
- Counterparties (the one offering the derivative);
- Liquidity (being unable to find a counterparties to offset the derivative
contract);
- Legal risk (the OTC CD contract may not be enforceable); and
- Valuation (CDs have many and varied valuation mechanisms which
make them hard to market or evaluate for two-way pricing).
• Most markets for derivatives assume risk neutrality and arbitrage
free conditions which may not necessarily exist for credit products
due to the unique bilateral situation between borrower and lender.
• By allowing credit risk to the freely traded, risk management of a
credit portfolio becomes far more flexible.
6
Credit Derivatives (cont.)
• For valuation, CDs are classified into two main
categories:- Replication products: priced on the capacity to replicate a money
market transaction (e.g. Credit spread options).
- Default products: priced as a function of the exposure underlying the
security, the default probability of the reference asset, and the expected
recovery rate (e.g. Credit default swaps).
• Other classifications include protection-like products
(e.g. Credit default options); and exchange-like products
(e.g. Total return swaps).
• We consider a selection of credit derivatives in more
detail.
7
1.1 Total Return Swaps (TRS)
• In a TRS, the buyer receives the
income and capital gain of a credit
asset.
• The TRS seller receives a set fee
from the buyer over the life of the
swap.
• If the price of the asset declines then
the buyer must compensate the
seller by the lost amount.
• The TRS allow the buyer to gain
exposure and benefit from a credit
asset without the ownership.
• The TRS is popular with hedge funds
because they get the benefit of a
large exposure with a minimal cash
outlay.
8
1.2 Credit Default Swaps (CDSs)
• A CDS is a financial agreement that the seller compensates the buyer
(the creditor of the reference loan/bond) in the event of default (by the
debtor).
• The buyer makes a series of payments (a "fee" or "spread") to the
seller and receives a payoff if the loan defaults.
• This effectively removes the need for specific insurance and is cheaper.
• If ‘No Default’:
- The protection buyer pays quarterly to the seller until maturity.
• If ‘Default Occurs’:
- The protection seller pays par value of the bond to the buyer; and
- The buyer transfers ownership of the defaulted bond to the seller.
• Maturities range from one to ten years.
• CDS data can be used by third parties to monitor how the market views
credit risk of any entity on which a CDS is available, this is similar to
that provided by the Credit Rating Agencies.
9
1.3 Credit Linked Notes (CLNs)• A CLN is a form of funded derivative
backed by a high quality asset such as
a US Treasury bond.
• It also contains an embedded credit
default swap allowing the transfer of
specific credit risk to investors.
• The note issuer is not obligated to
repay the debt is a specific event of
default occurs.
• CLNs pass the risk of specific default
onto investors willing to bear that risk
in return for higher rates of return.
• CLNs are issued by a SPV company
or trust, designed to offer investors par
value at maturity unless the referenced
entity defaults. In the case of default,
the investors receive a recovery rate.
• CLNs have been subject to fraud and
other malfeasance (e.g. Parmalat)
10
2.0 Common Structured Products
11
2.1 Collateralised Debt Obligations (CDOs)
• A CDO is an important class of ABS and MBS.
• Think of it as a promise to pay investors in a
pre-determined way, based on the cash flow
the CDO collects from the pool of bonds or
other assets it owns.
• It is sliced into "tranches“ based on credit
quality, which "catch" the cash flow of interest
and principal payments.
• If some loans default and the cash collected by
the CDO is insufficient to pay all of its investors,
those in the lowest tranches suffer losses first.
• The last to lose payment from default are the
safest, most senior tranches.
• Consequently interest rates and payments vary
by tranche with the safest tranches paying the
lowest rates of return and the lowest tranches
paying the highest rates - this compensates for
the risk of default across the tranches.
12
2.2 Collateralised Loan Obligations (CLOs)
• Under a CLO payments from multiple business loans are pooled and
are passed on to different classes of investors in various tranches.
• The loans are multi-million dollar syndicated loan originated by a bank
which then discharges it off the balance sheet through a CLO.
• CLOs were “invented” to increase the liquidity of the investor pool
thereby lowering the cost of borrowing to businesses.
• They also allow for lower quality loans to exit the balance sheet (of a
bank) which then diverts capital into higher quality assets.
• A CLO consists of “tranches” which are layers of investments
differentiated by credit quality.
• The lowest class of investor bears the greatest risk of default but do, on
average, receive the highest rate of interest income.
• By pooling loans into tranches, diversifies risk and return in the one
vehicle.
• Firms with bad or no ratings can borrow cheaply through CLOs.
13
2.3 Synthetic CDOs and CLOs
• Synthetic CDOs do not rely on the cash flows of the collateral asset
(e.g. Mortgage) pool.
• Instead, credit derivatives are used to link the performance of
securities issued by the SPV to the performance of some reference
pool of assets (e.g. An MBS index).
• There is no asset sale under a synthetic CDO, they stay on the
originator’s balance sheet;
• Such synthetic structures involve triggers based on:- Ratings distributions;
- Diversity scores;
- Collateral values;
- Losses;
- Defaults.
• These triggers are structural elements providing protection to note
holders, comparable to coverage tests.
14
3.0 Market Observations
• Up to 2007 there was an
abundance of cheap money
available for financing all kinds
of assets.
• Too much money chasing too
few deals e.g. Subprime
mortgages.
• Investment grade CDOs
offered returns far greater than
other investment grade assets.
• For example, in 2006 BBB-
rated CDOs yielded up to 900
basis points above LIBOR or
about 13% return per annum.
15
3.0 Market Observations
• During the GFC demand for CLOs
tumbled markedly from the Q1
2007 peak.
• During 2008 there were virtually
no new issues of CLOs.
• During 2012, the issuance of
CLOs has increased to around
US$55 billion, a level not seen
since Q2 2005.
• In 2013 alone this had increased
to $US82 billion last seen in Q4
2005.
• Whether CLO issuance will repeat
its 2007 performance remains to
be seen.
16
4.0 Summary
• In this topic we considered credit derivatives and their
application to credit risk management.
• We examined a number of popular products such as- Total Return Swaps (TRS);
- Credit Default Swaps (CDS);
- Credit Linked Notes (CLN);
- Collateralised Debt Obligations (CDO);
- Collateralised Loan Obligations (CLO); and
- Synthetic CDOs and CLOs.
• We considered the growth in credit derivatives from 2006
and how the GFC impacted the need for credit protection.
• Topic 8 considers the management of credit risk on a
portfolio basis.
Thank you and good luck!
Top Related