Credit derivatives cont

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Lecture 15

• Credit derivatives cont
• Summary of credit risk management
• Operational risk

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Total Return Swaps

• (TRS) are contracts where one party, called the
  protection buyer, makes a series of payments
  linked to the total return on a reference asset
• They are also called assets swaps, exchange,
• the protection seller makes a series of payments
  tied to a reference rate, such as the yield on an
  equivalent Treasury issue (or LIBOR) plus a
  spread.
• If the price of the asset goes down, the
  protection buyer receives a payment from the
  counterparty
• If the price goes up, a payment is due in the
  other direction

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• This type of swap is tied to changes in the
  market value of the underlying asset and provides
  protection against credit risk

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• The TRS has the effect of removing all the
  economic risk of the underlying asset without
  selling it.
• Example
• Suppose that a bank, call it Bank A, has made a
  100 million loan to company XYZ at a fixed rate
  of 10 percent. The bank can hedge its exposure by
  entering a TRS with counterparty B, whereby it
  promises to pay the interest on the loan plus the
  change in the market value of the loan in
  exchange for LIBOR plus 50bp. If the market value
  of the loan increases, bank A has to make a
  greater payment. Otherwise, its payment will
  decrease, possibly becoming negative.

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Example cont

• Say that LIBOR is currently at 9 percent and that
  after one year, the value of the loan drops from
  100 to 95 million. The net obligation from Bank
  A is the sum of
• Outflow of 10 x 100 10 million, for the
  loans interest payment
• Inflow of 9.5 x 100 9.5 million, for the
  reference payment
• Outflow of (95-100)/100)) x 100 -5 million,
  for the movement in the loans value
• This sums to a net receipt of 10- 9.5- (-5)
  5.5 million. Bank A has been able to offset the
  change in the economic value of this loan by a
  gain on the TRS

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Credit Spread Forward and Options

• These instruments are derivatives whose value is
  tied to an underlying credit spread between a
  risky and risk-free bond
• In a CSF, the buyer receives the difference
  between the credit spread at maturity and an
  agreed-upon spread, if positive.
• Conversely, a payment is made if the difference
  is negative

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• In a Credit spread option, the buyer pays a
  premium in exchange for the right to put any
  increase in the spread to the option seller at a
  predefined maturity

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Example of credit spread option

• A credit spread option has a notional of 100
  million with a maturity of one year. The
  underlying security is an 8 10-year bond issued
  by the 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 yields have moved
  from 6.5 to 6 and the credit spread has widened
  to 180bp
• The price of an 8 coupon, 9-year semiannual bond
  discounted at yS 61.8 7.8 is 101.276.
• The price of the same bond discounted at yK 6
  1.6 7.6 is 102.574.
• Using the notional amount, the payout is (102,574
  - 101,276)/100 x 100,000,000 1,297,237.

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Credit risk management - Summary

• Pooling together all the previous points in
  credit risk discussion, we can now summarize
  credit risk management.
• Like VaR for market risk, credit VaR (CVAR)can be
  measured and managed
• Credit VAR WCL ECL
• WCL is worst credit loss is the loss that will
  not be exceeded at some level of confidence
• Unexpected loss is the difference between worst
  and expected losses
• Most of the times, UCL depends on the
  distribution of joint default rates
  (correlation), among other factors

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Credit risk management - Summary

• Notably, the dispersion in the distribution
  narrows as the number of credits increases and
  when correlations among defaults decrease.
• Institutions should have enough capital to cover
  the unexpected losses
• CVAR is measured over a target horizon, say one
  year
• The horizon is deemed sufficient for the
  institution to take corrective actions should
  credit problems start to develop

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Credit risk management - Summary

• Corrective action can take the form of exposure
  reduction or adjustment of economic capital, all
  of which take considerably longer than the
  typical horizon for market risk
• The portfolio manager can examine the credits
  that contribute most to CVAR.
• If these credits are not particularly profitable,
  they should be eliminated

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Operational Risk
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What is operational risk

• The risk of loss resulting from inadequate or
  failed internal process, people, and system or
  from external events
• Basel committee has identified several loss
  categories
• 1. Internal fraud
• Unauthorized activity, theft or fraud, that
  involves at least one internal party -

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Loss categories in operational risk

• 2. External fraud
• Refers to theft or fraud carried out by a third
  party outside the organization theft, robbery,
  compute hacking, theft of information
• 3. Employment practices and workplace safety
• -employees compensation claims, wrongful
  termination, volition of safety and health rules,
  discrimination claims, harassment

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Loss categories in operational risk

• 4. Clients, products, and business practices
  Losses arising from a failure to meet an
  obligation to a client, or from nature or design
  of products
• Misuse of confidential clients information
• Money laundering
• Product defects
• Exceeding clients exposure limits
• 5. Damage to physical assets
• Losses arising out of disaster or other events
  natural disasters, terrorism or vandalism

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Loss categories in operational risk

• 6. Business disruption and system failures
• -hardware and software failures
• -Telecommunications problems
• -Power outages/disruptions
• 7. Execution, delivery, and process management
• -risk associated with transaction processing,
  trade counterparties for example,
  miscommunication, data entry errors, accounting
  errors, vendor disputes, outsourcing

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• According to Basel II, banks must hold capital
  for operational risk that is equal to the average
  of the previous three years of a fixed percentage
  (a) of positive annual gross income, which means
  that negative gross income figures must be
  excluded
• where K is the capital charge
• Y positive gross income over the previous three
  years

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• and n the number of the previous three years for
  which gross income is positive
• The fraction a is fixed by the Basel Committee at
  15 percent
• For the purpose of estimating K, the Committee
  defines gross income as net interest income plus
  net non-interest income as defined by the
  national supervisors and/or national accounting
  standards

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• The Committee suggests that the recognition of Y
  requires the satisfaction of the following
  criteria (i) being gross of any provisions,
• (ii) being gross of operating expenses,
• (iii) excluding realized profi ts/losses from the
  sale of securities, and
• (iv) excluding extraordinary and irregular items
  as well as income from insurance claims.

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The Standardized Approach

• Accepting that some financial activities are more
  exposed than others to operational risk (at least
  in relation to gross income), the BCBS divides
  banks activities into eight business lines.
• The capital charge for each business line is
  calculated by multiplying gross income by a
  factor (ß) that is assigned to each business
  line.
• (ß) is essentially the loss rate for a particular
  business line with an average business and
  control environments.

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• The total capital charge is calculated as a
  three-year average of the simple sum of capital
  charges of individual business lines in each year
• Hence
• Where j is set by the Basel Committee to relate
  the level of required capital to the level of
  gross income for business line j.

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Examples of activities falling under business
lines
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Examples of activities falling under business
lines
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The advanced measurement approach

• The BCBS (2004a) suggests that if banks move from
  the BIA along a continuum toward the AMA, they
  will be rewarded with a lower capital charge
• The BCBS makes it clear that the use of the AMA
  by a certain bank is subject to the approval of
  the supervisors.
• The regulatory capital requirement is calculated
  by using the banks internal operational risk
  measurement system.

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• The Committee considers insurance as a mitigator
  of operational risk only under the AMA
• Under this approach, banks must quantify
  operational risk capital requirements for seven
  types of risk and eight business lines, a total
  of 56 separate estimates

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• The Basel II accord allows three alternative
  approaches under the AMA
• (i) the loss distribution approach (LDA)
• (ii) the scenario-based approach (SBA) and
• (iii) the scorecard approach (SCA), which is also
  called the risk drivers and controls approach
  (RDCA).
• The three approaches differ only in the emphasis
  on the information used to calculate regulatory
  capital