Introduction To Credit Derivatives Stephen P. D

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Introduction To Credit DerivativesStephen P.
DArcy and Xinyan Zhao
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What are Credit Derivatives?

• Credit derivatives are derivative instruments
• that seek to trade in credit risks.
• http//www.credit-eriv.com/meaning.htm

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What are Derivatives?

• A financial contract that has its price
  derived from, and depending upon, the price of an
  underlying asset.
• The underlying assets might be traded.
• Types of Derivatives include, Swaps, Options
  and Futures for example.

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What is Credit Risk?

• The risk that a counterparty to a financial
  transaction will fail to fulfill their
  obligation.

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Growth in Credit DerivativesSourceBBA Credit
Derivatives Report 2006
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Types of credit derivatives

• Credit default swap
• Credit spread option
• Credit linked note

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What is Credit default swap?

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

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Example

• Suppose Bank A buys a bond which issued by a
  Steel Company.
• To hedge the default of Steel Company
• Bank A buys a credit default swap from
  Insurance Company C.
• Bank A pays a fixed periodic payments to C, in
  exchange for default protection.

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Exhibit

• Credit Default Swap

Credit Risk
Bank A Buyer
Insurance Company C Seller
Premium Fee
Contingent Payment On Credit Event
Steel company Reference Asset
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What is credit spread option?

• A 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.

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Credit Spread

• The different between the yield on the
  borrowers
• debt (loan or bond) and the yield on the
  referenced
• benchmark such as U. S. Treasury debt of the
  same
• maturity.

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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.

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Exhibit
Profit
Strike price
Spot price
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Credit-linked notes

• A credit-linked note (CLN) is essentially a
  funded CDS, 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 entitys debt.

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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 As repayment
  obligation on the note will decrease by just
  enough to offset its loss on the loan.

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Exhibit
1 Million
Bank A
Institutional investors
fixed or floating coupon,if defaults or declares
bankruptcy the investors receive an amount equal
to the recovery rate
1million
500b p Steel Company
Steel Company
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Credit Derivatives Market
ParticipantsSourceBritish Bankers Association
(BBA) 2003/2004 Credit Derivatives Report
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For the protection buyer(the risk seller)

• to transfer credit risk on an entity
  without transferring the underlying instrument
  regulatory benefit reduction of specific
  concentrations portfolio management
• to go short credit risk

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Credit Derivatives Market
ParticipantsSourceBritish Bankers Association
(BBA)
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For the protection seller(the risk buyer)

• diversification
• leveraged exposure to a particular credit
• access to an asset which may not
• otherwise be available to the risk buyer
• sourcing ability
• increase yield

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Questions

• Does your bank use credit derivatives? If yes,
• a. What type?
• b. How long?
• What is the primary purpose?

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• Do you think that most bankers in China
  understand credit derivatives? If not,
• a. What could help them understand credit
  derivatives better?
• b. What would be the most effective way to help?

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• Do you think banks in China should use credit
  derivatives to manage credit risk?
• a. What problems need to be solved to improve
  risk management?
• b. Do regulations need to be changed?