Credit Derivatives

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Energy Finance and Credit Summit 2004 Risk
Limited, Sungard and Deloitte (Sponsors) Four
Seasons Hotel, Houston, Texas Friday, February
27, 2004 Leslie K. McNew Clinical Professor,
Finance and Director of the Trading Center AB
Freeman School of Business, Tulane University,
New Orleans 504-865-5036 Lmcnew_at_tulane.edu
Credit Derivatives
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Growth in Credit Derivatives Market
End 2001 1.2 Trillion End 2002 1.5 Trillion
1996
2000
1999
1998
1997
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Growth in Credit Derivatives Market

• Credit Derivatives
• Newest of the derivative markets
• Developed around 1992-1993
• Used to manage and exploit risks/opportunities
  in credit markets
• Risk transferred among participants----off or on
  balance sheet transactions

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Growth in Credit Derivatives Market

• London is the dominant financial center
• Size of the international debt market
• A market-friendly regulatory environment
• Liquid asset swap market
• Derivative strengths

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Definitions
Credit Derivative a credit derivative allows
the holder to isolate and separate credit risk
from market risk, thus allowing this credit
risk to be either hedged, traded, or
transferred. A premium may be due. Credit
Default Swap enables isolation and transfer of
credit risk without transferring ownership of
the asset Digital Derivative cash settled
transaction (does not need delivery of
underlying asset upon settlement) Total
Return Swap transfer credit risk by swapping an
underlying assets specified total return
(capital growth and interest) between two
counterparties, in return for regular
payments of LIBOR spread LIBOR the
London inter-bank offer rate. The inter-bank
rate used when one bank borrows from another.
It is also the benchmark used to price many
capital market and derivative
transactions. Credit Spread difference in
yields between an agreed reference rate and
a specific asset in question. London gilt
market US treasury market Off-balance
sheet instrument or trade does not have to be
admitted to the firms balance sheet (can be
hidden)
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Credit Derivative Trigger Events

• Payment default or bankruptcy/insolvency in the
  case of corporate credits
• Moratorium on payments or the rescheduling of
  payments, as well as payment default
• itself, for sovereign credits
• Chapter 11 or bankruptcy filing by the issuer
• failure to meet payment obligations when due
• rating downgrade below an agreed upon level
• change in the agreed credit spread (over a
  government bond or compared to another
• government bond)
• A materiality threshold (a significant price
  decline) has also to be breached and
  independently agreed.

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Fee Determinants for Credit Derivatives

• credit rating or probable swap counterparty
• maturity
• probability of default
• expected value of the asset (post-default)

Prices from around the time of the California
energy crisis
Basis point conversion to decimal example, 50
bps 50/10,000 .005
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Why Use Credit Derivatives? Protection Buyer

• 4 Main Reasons
• Reduce exposure to a company or bank whose credit
  rating is deteriorating
• To free up credit lines so that higher margin
  businesses may be transacted
• To protect against a downgrading below a
  portfolio managers internal limits
• To reduce credit exposures which have exceeded
  limits, possibly where interest rates or currency
  movements have exceeded expectations

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Credit Default Swap in Energy Market

• Energy Company has a large exposure to Duke due
  to trading activities
• Energy Company wishes to reduce default risk to
  Duke
• Energy Company buys credit derivative from
  Investment Bank to reduce (insure) Duke credit
  risk exposure purchases a DITIGAL instrument
• Investment Bank only pays out notional amount to
  Energy Company if Duke experiences a default
  event (see Triggers)

Energy Company
Energy Company pays 82 basis points to receive,
within 1 year, 10 M from the Investment Bank if
Duke Energy defaults
Receive notional amount of credit protection
If Duke defaults within one year, the Energy
company owns default insurance that will pay
10 M regardless of the amount of the Duke default
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Total Return Swap
Instead of lump sum notional payment in the event
of default, the protection buyer receives a
specified economic value for the reference credit.
Total Return Payer is the Energy Company (X) ---
seller of risk, buyer of protection Total Return
Receiver is the Investment Bank (Y) buyer of
risk, seller of protection Reference Asset could
be bond of another energy company that Energy
Company (X) has credit risk exposure
Reference Asset

• Energy Company (X) pays any appreciation on the
  capital value of the underlying asset as well as
  any coupons receivable
• Investment Bank (Y) pays Energy Company (X) any
  depreciation of the capital value as well as a
  LIBOR linked floating margin
• Energy Company (X) is guaranteed a specified
  capital value for the underlying, as well as a
  LIBOR linked income for the duration of the swap
• Investment Bank (Y) owns the credit risk, as
  well as any income and any profits generated by
  this asset
• Energy Company (X) retains the ownership of the
  reference asset, and must continue to fund the
  asset (reference asset)
• If there is no credit event, there will be no
  contingent payment

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Total Return Swap
Total Return Payer is the Energy Company (X) ---
seller of risk, buyer of protection Total Return
Receiver is the Investment Bank (Y) buyer of
risk, seller of protection Reference Asset could
be bond of another energy company that Energy
Company (X) has credit risk exposure

• Why Use Total Return Swaps?
• lock in a specified economic value for the
  duration of the swap
• transfer the market risk of an asset off-balance
  sheet to lower regulatory charges
• used for trading credits on a leverage
  off-balance sheet basis

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Credit Spreads
Credit Spread difference in yields between an
agreed reference rate and a specific asset in
question. London gilt market US treasury
market

• Example
• T0 Corporate bond trades at 55 basis points
  over gilt
• T1 Corporate bond now trades at 45 basis
  points over gilt
• the credit spread has narrowed (tightened)
• credit quality of bond/bond issuer has improved
• WIDER CREDIT SPREADS IMPLY MORE LIKELY
• CHANCE OF DEFAULT

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Credit Spreads
2 Distinct Versions Credit spread relative to
benchmark Credit spread between two
credit-sensitive assets Easiest way to enter
transaction is through OPTIONS Credit spread
options enable trading/hedging of changes in
credit quality of the specified reference
credit Strike set at a particular credit spread
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Credit Spread Options
Payoff Cspread(T)(K) (spread(T) K) x
notional amount x risk factor Where Spread(T)
the spread for the financial asset over the
risk-less rate at the maturity of the
option K the specified strike spread
Notional amount a contractually specified
dollar amount equal to the amount that needs
to be hedged Risk Factor based on measures of
duration and convexity For a description of
duration, convexity and other financial
calculations, purchase Mastering Financial
Calculations, Robert Steiner, Financial
Times/Pitman Publishing, 1998, refer to chapter 5
for bond market calculations, and chapter 9 for
options
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Credit Spread Options

1. Energy Company X is concerned about a credit
   downgrade of one of its counterparties
2. Current counterparty is trading A rating,
   Energy Company X is concerned it will be
   downgraded to a B
3. Energy Company X buys downgrade protection in
   the form of a credit spread option
4. If the credit spread on its counterparties
   widens, downgrade from A to B, Energy Company
   X receives a payout
5. Energy Company X buys a call option on the credit
   spread (widening spread) and pays a premium

In basis points
In basis points
Basis point conversion to decimal example, 50
bps 50/10,000 .005
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Credit Spread Options
Option payout change in credit spread x
notional amount x risk factor Option payout
(300-150)/10,000 x 1,000 x 1.867 28.00
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First to Default Basket Options Notional Payout
Just as a portfolio manager may purchase
protection on a single name (credit), said
manager may also purchase protection on a basket
of names (credits) two or more. In the case of
the FIRST TO DEFAULT STRUCTURE, the credits in
the basket are protected against default for a
set notional amount. The risk credit to default
triggers the basket payout and basket
termination. At this point, the other credits
are left un-hedged, and most be re-hedged.
FIRST TO DEFAULT BASKET

Duke Energy Corp
American Electric Power
Sempra Energy
Reliant Energy Inc
El Paso Electric Co
Southern Co
Dynegy Inc
NexCollateral receives 10 M if ONE of the
baskets participants defaults
10 M Notional Total
FIRST TO DEFAULT BASKETS are generally suited for
investment-grade credits with low correlations
and low covariance
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First to Default Baskets vs. Straight Credit
Default Derivatives
COST SAVINGS
FIRST TO DEFAULT BASKETS are generally suited for
investment-grade credits with low correlations
and low covariance
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PRACTICAL EXAMPLES
APPENDIX E - CREDIT RISK LIMITS
Table 1 Portfolio Mix Limits, secured by
parental guarantees
Maximum of
Actual Policy of Midwestern Utility
Outstanding Exposure

Rating
Max. Tenor
By Rating Category
AAA
3 years
N/A
AA
3 Years
N/A
A
3 Years
50
(1)
BBB
2 Years
30
Collateral (security) comes in different formats


Cash


Securities


Treasuries
Can be converted to cash in case of default


Surety Bonds


Letters of Credit


Parental Guarantees
Promise made on behalf of parent to secure
activity undertaken by subsidiary, to a specific
entity (contractual form). At current time,
promise only secures the pre settlement and
settlement risk of actual transactions, no VaR or
liquidated damages. Specific entity usually must
seek legal recourse to recover against this form
of collateral in the case of default.



In Energy industry, large percentage of trading
partners rated BBB or less, and the convention
is to secure transactions with parental
guarantees

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PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives
APPENDIX E - CREDIT RISK LIMITS
Table 1 Portfolio Mix Limits, secured by
parental guarantees
Maximum of
Actual Policy of Midwestern Utility
Outstanding Exposure

Rating
Max. Tenor
By Rating Category
AAA
3 years
N/A
AA
3 Years
N/A
A
3 Years
50
(1)
BBB
2 Years
30

• Problem
• 1. Corporate does not want to have significant
  portfolio exposure
• to BBB risk
• Corporate does not want to have significant
  portfolio exposure
• to parental guarantees as security
• Energy industry, as practice, transacts on
  parental guarantees
• Energy industry participants heavily weighted
  toward BBB
• Need large liquid pool from which to transact to
  make

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PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives
APPENDIX E - CREDIT RISK LIMITS
Table 1 Portfolio Mix Limits, secured by
parental guarantees
Maximum of
Actual Policy of Midwestern Utility
Outstanding Exposure

Rating
Max. Tenor
By Rating Category
AAA
3 years
N/A
AA
3 Years
N/A
A
3 Years
50
(1)
BBB
2 Years
30
Answer Secure all BBB parental guarantee
participants beyond 30 threshold with credit
derivatives Mitigate the portfolio credit
risk by buying protection










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PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives

• Individual Counterparty Hedge
• Set traditional credit limit
• Purchase protection in form of default credit
  derivative against credit limit (limit and
  notional amount must match)
• Mitigate all credit exposure to counterparty by
  above off-balance sheet transaction (transferred
  risk to AA rated investment bank --- always
  risk that said bank will default)
• Monitor available credit such that it does not
  exceed credit limit
• Charge traders or profit center for cost of
  credit derivative
• 100 compliance with policy while still allowing
  trading liquidity

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PRACTICAL EXAMPLES
Counterparties Over Credit Limit

• Problem/Resolution
• Traders/marketers put deal in system that
  breaches credit limits
• Discipline action required (see policy)
• Company now exposed to greater risk than desired
• Purchase default derivative to cover risk until
  situation can be resolved
• Charge person/group responsible for cost of
  protection (against their P/L)

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PRACTICAL EXAMPLES
Credit in High Volatility Months
Example, summer is high volatility for power.
Keep the deals on the book, get paid for the
extra risk that the company is taking.
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PRACTICAL EXAMPLES
Credit in High Volatility Months
Total Return Swap
lock in a specified economic value for the
duration of the swap

1. Energy Company X will raise credit limits during
   high vol months
2. Energy Company X takes on more risk during this
   period and wishes to be compensated for said risk
3. Total return swap pays Energy Company X a rate
   equal to LIBOR spread, and any depreciation on
   asset (Dynegy)
4. Energy Company X pays investment bank any
   appreciation on asset (Dynegy)
5. Energy Company X earns a higher rate of return
   during the swap, which compensates it for the
   increased risk that it is assuming

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PRACTICAL EXAMPLES

• Problem
• Rumors in energy industry indicate that problems
  are brewing in California market (possibility of
  credit defaults)
• Energy company X has large position due to
  trading transactions with PGE
• Energy company X wants a credit hedge to offset
  against any cash flow problems PGE may incur
  (credit manager is hearing rumors, and wants some
  protection, but not costly protection
• Energy company X credit manager buys credit
  spread call (credit widening---possibility of
  default greater), struck at current spread level,
  on PGE
• Energy company X credit manager buys call against
  current mark to market position (notional amount
  of call equals current mark to market credit risk
  position with PGE)

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PRACTICAL EXAMPLES
Credit Spreads Against Credit Migration Downward
Current credit spread is 72 bps., and credit
manager sets notional amount at 10 M. Credit
spread widens to 600 bps after 6 months, and the
option pays out over 3 M. If the credit manager
had been wrong on acting on the rumor, the cost
of the option would have been minimal. As it
was, the credit manager acted, and although PGE
did not default, the spread widen to compensate
the credit manager for the extra risk her
portfolio had taken to transact with PGE
Credit spread has widened from 72 bps to 600 bps
after 6 months, and Energy Company X gets out of
option
Payment of premium
Breakeven
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Optimal Credit Protection Column
Parental Guarantees
Payoff based on recovery percentage
Credit Derivatives
All of payoff in event of default situation
Letters of Credit
Credit Portfolio Insurance
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Type in stock ticker (AEP) After stock ticker,
space, type CORP GO Select Corporate Bond
desired for analysis
Using Bloomberg
Example of a List of Corporate Bonds
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Select Corporate Bond Then, when inside bond, ASW
GO
Using Bloomberg
corporation
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Good way to get an estimation, actual quotes
differ by 20-50 bps.
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Using Bloomberg
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