Zvi Wiener

1
Financial Risk Management

• Zvi Wiener
• Following
• P. Jorion, Financial Risk Manager Handbook

2
Chapter 22Credit Derivatives

• Following P. Jorion 2001
• Financial Risk Manager Handbook

3
Credit Derivatives

• From 1996 to 2000 the market has grown from
• 40B
• to
• 810B
• Contracts that pass credit risk from one
  counterparty to another. Allow separation of
  credit from other exposures.

4
Credit Derivatives

• Bond insurance
• Letter of credit
• Credit derivatives on organized exchanges
• TED spread Treasury-Eurodollar spread
• (Futures are driven by AA type rates).

5
Types of Credit Derivatives

• Underlying credit (single or a group of entities)
• Exercise conditions (credit event, rating,
  spread)
• Payoff function (fixed, linear, non-linear)

6
Types of Credit Derivatives

• November 1, 2000 reported by Risk
• Credit default swaps 45
• Synthetic securitization 26
• Asset swaps 12
• Credit-linked notes 9
• Basket default swaps 5
• Credit spread options 3

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Credit Default Swap

• A buyer (A) pays a premium (single or periodic
  payments) to a seller (B) but if a credit event
  occurs the seller (B) will compensate the buyer.

B - seller
A - buyer
Reference asset
8
Example

• The protection buyer (A) enters a 1-year credit
  default swap on a notional of 100M worth of
  10-year bond issued by XYZ. Annual payment is 50
  bp.
• At the beginning of the year A pays 500,000 to
  the seller.
• Assume there is a default of XYZ bond by the end
  of the year. Now the bond is traded at 40 cents
  on dollar.
• The protection seller will compensate A by 60M.

9
Types of Settlement

• Lump-sum fixed payment if a trigger event
  occurs
• Cash settlement payment strike market value
• Physical delivery you get the full price in
  exchange of the defaulted obligation.
• Basket of bonds, partial compensation, etc.
• Definition of default event follows ISDAs Master
  Netting Agreement

10
Total Return Swap (TRS)

• Protection buyer (A) makes a series of payments
  linked to the total return on a reference asset.
  In exchange the protection seller makes a series
  of payments tied to a reference rate (Libor or
  Treasury plus a spread).

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Total Return Swap (TRS)
B - seller
A - buyer
Reference asset
12
Example TRS

• Bank A made a 100M loan to company XYZ at a
  fixed rate of 10. The bank can hedge the
  exposure to XYZ by entering TRS with counterparty
  B. The bank promises to pay the interest on the
  loan plus the change in market value of the loan
  in exchange for LIBOR 50 bp.
• Assume that LIBOR9 and by the end of the year
  the value of the bond drops from 100 to 95M.
• The bank has to pay 10M-5M5M and will receive
  in exchange 90.5M9.5M

13
Credit Spread Forward

• Payment (S-F)DurationNotional
• S actual spread
• F agreed upon spread
• Cash settlement
• May require credit line of collateral
• Payment formula in terms of prices
• Payment P(yF, T)-P(yS,T)Notional

14
Credit Spread Option

• Put type
• Payment Max(S-K, 0)DurationNotional
• Call type
• Payment Max(K-S, 0)DurationNotional

15
Example

• A credit spread option has a notional of 100M
  with a maturity of one year. The underlying
  security is a 8 10-year bond issued by
  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 yield has
  moved from 6.5 to 6 and the credit spread
  widened to 180bp.
• The price of an 8 coupon 9-year semi-annual bond
  discounted at 61.87.8 is 101.276.
• The price of the same bond discounted at
  61.67.6 is 102.574.
• The payout is (102.574-101.276)/100100M
  1,297,237

16
Credit Linked Notes (CLN)

• Combine a regular coupon-paying note with some
  credit risk feature.
• The goal is to increase the yield to the investor
  in exchange for taking some credit risk.

17
CLN
A buys a CLN, B invests the money in a high-rated
investment and makes a short position in a credit
default swap. The investment yields LIBORYbp,
the short position allows to increase the yield
by Xbp, thus the investor gets LIBORYX.
18
Credit Linked Note
CLN AAA note Credit swap
Credit swap buyer
investor
AAA asset
Asset backed securities can be very dangerous!
19
Types of Credit Linked Note

• Type Maximal Loss
• Asset-backed Initial investment
• Compound Credit Amount from the first default
• Principal Protection Interest
• Enhanced Asset Return Pre-determined

20
FRM 1999-122 Credit Risk (22-4)

• A portfolio manager holds a default swap to hedge
  an AA corporate bond position. If the
  counterparty of the default swap is acquired by
  the bond issuer, then the default swap
• A. Increases in value
• B. Decreases in value
• C. Decreases in value only if the corporate bond
  is downgraded
• D. Is unchanged in value

21
FRM 1999-122 Credit Risk (22-4)

• A portfolio manager holds a default swap to hedge
  an AA corporate bond position. If the
  counterparty of the default swap is acquired by
  the bond issuer, then the default swap
• A. Increases in value
• B. Decreases in value it is worthless (the same
  default)
• C. Decreases in value only if the corporate bond
  is downgraded
• D. Is unchanged in value

22
FRM 2000-39 Credit Risk (22-5)

• A portfolio consists of one (long) 100M asset
  and a default protection contract on this asset.
  The probability of default over the next year is
  10 for the asset, 20 for the counterparty that
  wrote the default protection. The joint
  probability of default is 3. Estimate the
  expected loss on this portfolio due to credit
  defaults over the next year assuming 40 recovery
  rate on the asset and 0 recovery rate for the
  counterparty.
• A. 3.0M
• B. 2.2M
• C. 1.8M
• D. None of the above

23
FRM 2000-39 Credit Risk

• A portfolio consists of one (long) 100M asset
  and a default protection contract on this asset.
  The probability of default over the next year is
  10 for the asset, 20 for the counterparty that
  wrote the default protection. The joint
  probability of default is 3. Estimate the
  expected loss on this portfolio due to credit
  defaults over the next year assuming 40 recovery
  rate on the asset and 0 recovery rate for the
  counterparty.
• A. 3.0M
• B. 2.2M
• C. 1.8M 1000.03(1 40) only joint default
  leads to a loss
• D. None of the above

24
FRM 2000-62 Credit Risk (22-11)

• Bank made a 200M loan at 12. The bank wants to
  hedge the exposure by entering a TRS with a
  counterparty. The bank promises to pay the
  interest on the loan plus the change in market
  value in exchange for LIBOR40bp. If after one
  year the market value of the loan decreased by 3
  and LIBOR is 11 what is the net obligation of
  the bank?
• A. Net receipt of 4.8M
• B. Net payment of 4.8M
• C. Net receipt of 5.2M
• D. Net payment of 5.2M

25
FRM 2000-62 Credit Risk (22-11)

• Bank made a 200M loan at 12. The bank wants to
  hedge the exposure by entering a TRS with a
  counterparty. The bank promises to pay the
  interest on the loan plus the change in market
  value in exchange for LIBOR40bp. If after one
  year the market value of the loan decreased by 3
  and LIBOR is 11 what is the net obligation of
  the bank?
• A. Net receipt of 4.8M (12-3)
  (110.4)200M
• B. Net payment of 4.8M
• C. Net receipt of 5.2M
• D. Net payment of 5.2M

26
Pricing and Hedging Credit Derivatives

• 1. Actuarial approach historic default rates
• relies on actual, not risk-neutral probabilities
• 2. Bond credit spread
• 3. Equity prices Mertons model

27
Example Credit Default Swap

• CDS on a 10M two-year agreement.
• A protection buyer agrees to pay to
• B protection seller a fixed annual fee in
  exchange for protection against default of 2-year
  bond XYZ.
• The payout will be Notional(100-B) where B is
  the price of the bond at expiration, if the
  credit event occurs.
• XYZ is now A rated with YTM6.6, while T-note
  trades at 6.

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Actuarial Method

• 1Y 1 probability of default
• 2Y 0.010.900.020.070.050.021.14

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Actuarial Method

• 1Y 1 probability of default
• 2Y 0.010.900.020.070.050.021.14
• If the recovery rate is 60, the expected costs
  are

1Y 1(100-60) 0.4 2Y 1.14(100-60)
0.456 Annual cost (no discounting)
30
Credit Spread Method

• Compare the yield of XYZ with the yield of
  default-free asset. The annual protection cost
  is
• Annual Cost 10M (6.60-6) 60,000

31
Equity Price Method

• Following the Mertons model (see chapter 21) the
  fair value of the Put is

The annual protection fee will be the cost of Put
divided by the number of years. To hedge the
protection seller would go short the following
amount of stocks