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Financial Risk Management. Zvi Wiener Following P. Jorion, Financial Risk Manager Handbook. Chapter 22 Credit Derivatives. Following P. Jorion 2001 Financial Risk Manager Handbook. Credit Derivatives. From 1996 to 2000 the market has grown from $40B to $810B

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Financial Risk Management


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    1. Financial Risk Management Zvi Wiener Following P. Jorion,Financial Risk Manager Handbook FRM

    2. Chapter 22Credit Derivatives Following P. Jorion 2001 Financial Risk Manager Handbook FRM

    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. Zvi Wiener

    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). Zvi Wiener

    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) Zvi Wiener

    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% Zvi Wiener

    7. premium Contingent payment 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 Zvi Wiener

    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. Zvi Wiener

    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 ISDA’s Master Netting Agreement Zvi Wiener

    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). Zvi Wiener

    11. Payment tied to reference asset Payment tied to reference rate Total Return Swap (TRS) B - seller A - buyer Reference asset Zvi Wiener

    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 LIBOR=9% and by the end of the year the value of the bond drops from $100 to $95M. • The bank has to pay $10M-$5M=5M and will receive in exchange $9+$0.5M=9.5M Zvi Wiener

    13. Credit Spread Forward Payment = (S-F)*Duration*Notional S – actual spread F – agreed upon spread Cash settlement May require credit line of collateral Payment formula in terms of prices Payment =[P(y+F, T)-P(y+S,T)]*Notional Zvi Wiener

    14. Credit Spread Option Put type Payment = Max(S-K, 0)*Duration*Notional Call type Payment = Max(K-S, 0)*Duration*Notional Zvi Wiener

    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 6+1.8=7.8% is $101.276. The price of the same bond discounted at 6+1.6=7.6% is $102.574. The payout is (102.574-101.276)/100*$100M = $1,297,237 Zvi Wiener

    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. Zvi Wiener

    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 LIBOR+Ybp, the short position allows to increase the yield by Xbp, thus the investor gets LIBOR+Y+X. Zvi Wiener

    18. par Xbp L+X+Y Contingent payment Contingent payment par LIBOR+Y Credit Linked Note CLN = AAA note + Credit swap Credit swap buyer investor AAA asset Asset backed securities can be very dangerous! Zvi Wiener

    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 Zvi Wiener

    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 Zvi Wiener

    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 Zvi Wiener

    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 Zvi Wiener

    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 = $100*0.03*(1– 40%) only joint default leads to a loss D. None of the above Zvi Wiener

    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 LIBOR+40bp. 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 Zvi Wiener

    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 LIBOR+40bp. 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%) –(11%+0.4%)]*$200M B. Net payment of $4.8M C. Net receipt of $5.2M D. Net payment of $5.2M Zvi Wiener

    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 – Merton’s model Zvi Wiener

    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 YTM=6.6%, while T-note trades at 6%. Zvi Wiener

    28. Starting Ending state Total State A B C D A 0.90 0.07 0.02 0.01 1.00 B 0.05 0.90 0.03 0.02 1.00 C 0 0.10 0.85 0.05 1.00 D 0 0 0 1.00 1.00 Actuarial Method 1Y 1% probability of default 2Y: 0.01*0.90+0.02*0.07+0.05*0.02=1.14% Zvi Wiener

    29. Actuarial Method 1Y 1% probability of default 2Y: 0.01*0.90+0.02*0.07+0.05*0.02=1.14% 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): Zvi Wiener

    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 Zvi Wiener

    31. Equity Price Method Following the Merton’s 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 Zvi Wiener