1 / 30

Credit Derivatives

Credit Derivatives. Credit Derivatives. A credit derivative  financial instrument Allows participants to decouple credit risk from an asset and place it with another party. Credit Risk.

bela
Download Presentation

Credit Derivatives

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Credit Derivatives

  2. Credit Derivatives • A credit derivative  financial instrument • Allows participants to decouple credit risk from an asset and place it with another party

  3. Credit Risk Credit risk is the risk of loss due to a Debtor's non-payment of a Loan or other line of Credit, either the Principal or Interest (Coupon) or both. To reduce or strip out Credit risk, Risk Manager may : Take Collateral Make loss provisions Actively manage the Credit Risk Exposure or use Credit Derivatives : Credit Default Swaps (CDS)

  4. Credit Risk • Downgrade Risk • - Rating agency reduces debtor’s credit rating • - Reduces value of debt • Default Risk • - Loan not repaid in full • - Future cash flows not certain

  5. Rating Agencies • Risk is measured by rating agencies • - Moody’s • - S&P • - Fitch • Rating scales:

  6. Types of Credit Derivatives • Credit Default Swap (almost 90% of all transactions) • Dynamic Credit Default Swap • Credit intermediation Swap • Basket Credit Default Swap • Total Rate of Return Swap • Credit (spread) Option • Downgrade Option • Collateralized Instrument • Credit-linked Note • Synthetic Collateralized Debt Obligation

  7. Credit Default Swaps CDS

  8. First CDS • introduced in 1995 by JP Morgan • in an attempt to free up all that capital they were obliged, by federal law, to keep in reserve in case any of their loans went ‘bad’. • Estimated Size of the CDS market (Q1 2008): • USD 65 trillion • Global GDP: USD 55 trillion (2007,IMF)

  9. Characteristics of Credit Default Swaps • Market of CDS is divided in three sectors: • Corporates • Bank credits • Emerging markets sovereign • OTC agreement (privately negotiated transactions) • CDS ranges in maturity from one to ten years • Five year maturity is the most frequently traded • CDS provides protection only against previously agreed upon credit events

  10. Credit Events • According to ISDA 2003 Master Agreement • Bankruptcy • (insolvency or inability to pay its debts) • Failure to pay • (principal or interest) • Debt Restructuring (change in the terms of the debt that are adverse for creditors) • Repayment Acceleration on Default • Repudiation • (sovereign only – indication that a debt is no longer valid) • One of this event has to have happened on the reference entity in order a CDS payment to be made

  11. What is a single CDS • Bilateral contract • Protection buyer pays premium to protection seller • Protection seller  contingent payment upon default of reference asset • One party usually owns the Reference asset • Otherwise: transaction does not involve credit exposure  speculation on behalf of both parties • Premium paid is known  CDS Spread

  12. Reference Asset • Bank loan • Corporate debt • Trade receivables • Emerging market debt • Convertible securities • Credit exposures from other derivatives

  13. CDS Spread • Quoted in Basis Points per annum • Paid periodically • If corporate quarterly • sovereign  monthly • Credit Spread =Default probability x (1-recovery rate) • Premium = notional amount x CDS spread p.a.

  14. Example on Premium of Bulgarian 5Y CDS • Notional amount = USD10,000,000 • Spread= 494 b.p. • Premium = notional amount x CDS spread • = 10,000,000 x 0.0494 • = 494,000 p.a.

  15. Payoff from CDS • The payoff can be defined in terms of • Physical delivery of the reference asset • delivery of the Defaulted Bond for the Par value (no later than 30 days after the credit event) • or • Cash Settlement • pays the Protection Buyer the difference between the Par value and (real) Recovery value of the Bond (within 5 days of the credit event) • Settlement terms of a CDS are determined when the CDS contract is written

  16. Buyers and sellers of protection

  17. Cash Settlement ExamplePayoff from a Credit Default Swap • Bank A holds a corporate bond issued by C • Reference asset Bond C, maturing in two years

  18. Cash Settlement ExamplePayoff from a Credit Default Swap • To reduce credit risk: • Bank A enters in two year CDS with Bank B, with notional amount 10 millions (protection buyer) • Bank B  contingent payment to A in the event of default of reference asset C (protection seller)

  19. Cash Settlement ExamplePayoff from a Credit Default Swap • Bank A pays periodically the premium to Bank B • CDS on C is quoted 52 bps (per annum) • Premium= notional Amount x CDS spread • = 10,000,000 x 0.0052 = 52,000

  20. Cash Settlement ExamplePayoff from a Credit Default Swap • After one year: • C defaults on the bond by declaring bankruptcy • Market value  falls to 48.63% of its par value • because • Market expectation is that C will only be able to pay back 48.63% of total outstanding

  21. Cash Settlement ExamplePayoff from a Credit Default Swap • The payoff on default will be calculated as follow • Notional principal x Par Value – Market Value 100

  22. Cash Settlement ExamplePayoff from a Credit Default Swap • Bank B  makes payment to Bank A • USD 10,000,000 x (100–48.63)/100 =USD 5,137,000

  23. Cash Settlement ExamplePayoff from a Credit Default Swap • Net effect • CDS  allowed Bank A to insulate itself from credit risk by holding the risky bond C • The payoff from sale of reference asset: • USD 10,000,000 x 48.63 = 4,863,000

  24. Cash Settlement ExamplePayoff from a Credit Default Swap • Bank A receives the recovery rate from the sale of the underlying reference asset USD 4,863,000 and payoff of USD 5,137,000 from Bank B • Total 10,000,000 • Bank Bacquired the credit risk of holding the bond without actually holding it in return for receiving the premium from BankA

  25. Use of CDS • Hedging • Protection buyer owns the underlying credit asset • Speculation • Protection buyer does not have to own the underlying asset

  26. Hedging • CDS  manage the credit risk • Protection buyer  hedge their exposure by entering into CDS contract • IF reference asset defaults  the proceeds from CDS will cancel out the losses on the underlying • Protection buyer  will have lost only the payments over that time • IF reference asset does not default protection buyer makes the payments reducing investments returns but eliminates the risk of loss due to reference entity defaults

  27. Speculation • Investor  speculates on changes in an entity’s credit quality • If credit worthiness declines => CDS spread will increase • If credit worthiness increases => CDS spread will decline • Example: a hedge fund believes an Entity will default soon  buys protection

  28. Speculation • IF reference asset defaults  • Protection buyer will have paid the premium but will receive from the protection seller the notional amount making a profit. • IF reference asset does not default  • CDS contract will run for whole duration without any return

  29. Speculation • The hedge fund could liquidate its position after a certain period of time  lock in its gains or losses • IF reference asset is more likely to default => CDS Spread widens • So, hedge fund  sells protection for the rest of CDS duration at a higher rate => makes profit (given that reference asset does not default during this time) • IF reference asset is much less likely to default => CDS spread tightens • So, hedge fund  again sells protectionfor the rest of CDS duration in order to eliminate the loss that would have occurred

More Related