1 / 59

Credit Derivatives

Credit Derivatives. 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion. Purposes. Transfer and repackaging of credit risk Default baskets and synthetic loss tranches New exposure to credit risk to leverage credit risk . Credit Derivatives Market.

serenity
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 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

  2. Purposes • Transfer and repackaging of credit risk • Default baskets and synthetic loss tranches • New exposure to credit risk to leverage credit risk

  3. Credit Derivatives Market • $2.306 trillion notional value in 2003 was a 50% increase from 2002 • Credit default swaps - 73% • Correlation products – Synthetic loss tranches and default baskets – 22% • U.S companies – 43.8% • European – 40.1% • U.S. has a much larger cash market

  4. Banks – 50% • Hedging and diversification • Insurance companies – 14% • Hedge funds – 13%

  5. Credit Default Swaps • Bilateral contract to transfer credit risk of a reference entity from one party (protection buyer) to another party (protection seller) • Protection buyer – shorting credit risk • Protection buyer makes regular payments (usually quarterly) know as the premium leg until credit event or maturity

  6. Protection buyer Default swap spread Protection seller Default swap mechanics If a default occurs, there is a cash settlement or physical settlement

  7. Cash settlement Protection buyer 100-recovery rate Protection seller Physical settlement Bond Protection buyer Protection seller 100%

  8. Pari Passu • From Wikipedia, the free encyclopedia • pari passu is a Latin phrase that means "at the same pace", and by extension also "fairly", "without partiality". • In finance this term refers to two or more loans, bonds or series of preferred stock having equal rights of payment, i.e., have the same level of seniority. In asset management firms, the term denotes an equal allotment of trades to strategically identical funds or managed accounts. • This term is also often used in bankruptcy proceedings where creditors are said to be paid 'pari passu', or each creditor is paid pro rata in accordance with the amount of his claim. Here its meaning is 'equally and without preference'.

  9. Physical settlement – most common • Requires protection buyer deliver notional amount to the seller for notional amount paid in cash. Generally, the deliverable instrument is a basket with restrictions on maturity and pari passu. The buyer is long a “cheapest-to-deliver” option.

  10. Cash settlement – not generally used in CDS, but is common in default baskets and synthetic CDOs

  11. CDS Maturity • Maturity tends to be one of 4 roll dates • 20th of March, June, September, and December • New contract 5-year contract on April 12th 2004 will mature June 20th 2009 • Assume contract has a spread of 160 bp • Convention is Actual/360 • Default occurs on August 18, 2005

  12. $10 million notional value • Assume contract has a spread of 160 bp • Convention is Actual/360 • Default occurs on August 18, 2005 • Cash price of deliverable asset = $34

  13. CDS Cash Flow

  14. Uses of CDS • Easy to short credit risk. Allows hedging of credit risk or for those with a bearish credit view. • CDS are unfunded so leverage is possible. • CDS are customizable in terms of maturity, seniority, and currency. Deviation from market standard may incur a liquidity cost.

  15. CDS can be used to take a spread view on credit. A CDS can be unwound to realize gains (or losses) owing to changes in credit spread, • Liquidity can be better than the cash market. Most liquid is 5-year. 3-year, 7-year, and 10-year are less liquid.

  16. International Swaps and Derivatives Association (ISDA) has a master agreement. • Reduces legal risk, speeds up confirmation, and therefore enhances liquidity. • However, CDS market is not standardized. U.S, European, and Asian markets are segmented.

  17. ISDA Credit Events • Bankruptcy – corporation becomes insolvent. • Failure to pay – reference entity does not make due payments, taking into account a grace period to avoid administrative error. • Restructuring – changes in the debt obligations of the reference creditor but excluding those that are not associated with credit deterioration, such as the renegotiation of more favorable crdit terms.

  18. Obligation acceleration/obligation default – Obligations become due and payable earlier than they would have been due to default or similar condition. • Repudiation/Moratorium – A reference entity or government rejects or challenges the validity of the obligations.

  19. Restructuring Clause • Following bankruptcy, pari passu assets should have the same recovery value. • After a restructuring • Short term may have higher value than long-term • High coupon bonds may be more valuable than low coupon bonds • Loans are more valuable than bonds due to covenants

  20. This makes a CDS valuable • Consider a protection buyer with a hedge on short-term debt trading at $80 while long-term debt trades at $65. • Buy the CDS, buy the long-term bond, and make delivery. An immediate $15 profit (at the expense of the protection seller). • 2000 – Restructuring of Conseco

  21. Old restructuring • Original standard for which delivery is a bond with a maximum maturity of 30 years

  22. Modified Restructuring (Mod-re) • Current standard in U.S. Roughly speaking, it limits the maturity of the deliverable to the maturity of the CDS contract plus 30 months.

  23. Modified-Modified-Restructuring (mod-mod-re) • Current European standard. it limits the maturity of the deliverable to the maturity of the CDS contract plus 60 months. It also allows the delivery of conditionally transferable obligations rather than only fully transferable obligations.

  24. No restructuring • Eliminates restructuring as a credit event.

  25. Restructuring and Spread • Contracts may be available with all four restructuring options. • No-re will have tightest spread. • Mod-re spread. • Mod-mod-re more valuable than mod-re and will have next widest spread. • Old-re should have widest spread

  26. CDS Formats • Swap format (unfunded format) • No initial payment • Counterparty risk • Credit-linked note (funded format) • Buyer has to buy fund the purchase of a high credit quality bond • At maturity, the bond is returned to the buyer

  27. Determining the CDS Spread • Before credit event Protection seller Default swap spread (D) Pay Hedged Investor (protection buyer) Asset Libor F LIBOR +B Borrows 100 Funding

  28. Before credit event • On the annual payment dates, hedged investor receives +F – D – B At maturity, buyer receives par from asset and repays borrowed amount

  29. Determining the CDS Spread • After credit event Protection seller Defaulted asset 100 Defaulted asset Hedged Investor (protection buyer) Repay 100 Funding

  30. After credit event • Buyer delivers the defaulted asst to seller in return for par and repays the funding loan with this principal (assume at par) • Strategy has no initial cost and is flat following credit event, so CF before event have to equal zero

  31. No arbitrage condition • D = F – B • Par floater = LIBOR + 25bp • Funding = LIBOR + 5bp • F = 25bp • B = 5bp • D = 25bp – 5bp = 20bp

  32. Not exact • Ignores accrued interest and coupon recovery • Also lacks adjustments for availability of cash, liquidity, supply and demand, and counterparty risk • Good starting point, and if incorrect by a lot, arbitrage may exist

  33. Default Swap Basis • CDS – unfunded proxy for cash bond • Divergence between CDS and cash bonds is default swap basis • Default swap basis = CDS spread – cash LIBOR spread • Positive basis – cash bond spread inside CDS spread • Negative basis – CDS spread inside cash LIBOR spread

  34. Divergence between cash and CDS spread • Fundamental factors • Market factors

  35. Fundamental Factors • 1) Funding • If buyer borrows cash to purchase a bond, and their credit quality is high, they may be able to issue below LIBOR. This means it may be better to buy bond than sell protection in CDS. If funding cost is above LIBOR, the reverse may be true.

  36. 2) The delivery option • The cheapest to deliver option may be valuable, so long position in CDS is more valuable than short position. Widens CDS spread and increases basis.

  37. 3) CDS protects par • Bonds can trade above or below par because of interest rates. Bonds with high (low) coupons exposes the to a greater (lower) credit risk. Bonds below par value should pay a lower spread than the CDS, bonds above par should pay a higher spread than default swaps.

  38. 4) Counterparty risk • Protection buyers will pay a lower spread because of counterparty risk. Posting collateral can reduce this risk.

  39. Market Factors • 1) Technical short • Hedging of synthetic loss tranches requires a significant amount of dealer hedging, reducing the basis.

  40. 2) Convertible issuance • Convertible equity funds use CDS to hedge credit risk in convertibles. This drives default swap spreads higher since there are few outstanding convertible bonds. Widening is usually not sustained and reverts to normalized levels.

  41. 3) Demand for protection • Negative view on credit can be traded in two ways - Bond can be sold short or CDS can be purchased. This can widen both cash and default swap spread. However, it is easier to do a CDS, so the widening of the spread is first observed in the CDS market.

  42. On October 22, 2001, Enron’s stock price dropped 20% to $20.65 per share, and five-year credit default swap (CDS) spreads jumped 20% to 48 basis points, after the Securities & Exchange Commission announced it was looking into the firm’s accounting practices. When Enron announced it had overstated profits by nearly $600m over five years on November 8, the stock was at $8.41 and CDS spreads were at 133bp. By the time Moody’s and S&P finally downgraded Enron to junk status on November 28, its stock was worth little more than a dollar per share. Bankruptcy was filed on December 2, 2001.

  43. The moral of the story, ‘don’t ignore the market’, was a hard lesson for the rating agencies to learn. Five years on, one agency, Moody’s, has something to show for it. • Moody’s, the oldest rating agency, and alongside Standard & Poor’s one of the two largest agencies by market share, has developed a set of ratings indicators derived from market signals. These may be used as a counterpart to Moody’s ‘normal’ ratings, which are based on analysts’ views of an issuer’s creditworthiness. • The indicators, dubbed ‘market implied ratings’ (MIR), highlight discrepancies between an issuer’s credit rating – in essence, the rating agency’s assessment of a company’s financial situation and future outlook – and the market’s view of that issuer – which is in effect the sum total of the expression of all bond, credit derivatives and equity investors’ views on that company.

  44. It might seem like something of a no-brainer that securities the market takes a dim view of are more likely to default; but what is surprising is the degree to which it is true. • Using a data set of 2,900 issuers, with 180,000 observations gathered between January 1, 1999 and February 28, 2006, the one-year default rate for B2 rated issuers trading two notches below their Moody’s rating was a massive 17.82%. That compares with a default rate of 3.61% for issuers trading flat to their Moody’s rating; or 0.59% for those trading two notches rich. In other words, if you held a portfolio of bonds that were trading two notches cheaper than the Moody’s rating, you should expect nearly a fifth of them to default within a year. • Market implied ratings (MIR) can also be used to predict potential ratings changes. An issuer trading three notches below its Moody’s rating is looking at about a 25% chance of downgrade over a one-year horizon, according to MIR data from the same data set.

  45. Valuing a CDS • Value at inception is zero – no cost to enter • Value will change over time • At inception: • E(PV) protection leg = E(PV) premium leg • Mark-to-market (MTM) value is the value the market would pay us to unwind the position

  46. Suppose a 5-year CDS was issued at a 250bp spread. In one year, the spread on the reference entity falls to 100bp. • MTM = E(PV) of premium leg of 250bp • - E(PV) of 4-year protection leg • New 4-year CDS: • E(PV) of premium leg of 250bp • - E(PV) of 4-year protection leg

  47. Substituting: • MTM = E(PV) of premium leg of 250bp • - E(PV) of 4-year premium pmts 100 bp • MTM = E(PV) of premium leg of 150bp

  48. Discount PV of 150bp payments. However, payments are made only until credit event, so: • MTM = 150bp * RPV01 RPV01 = risky PV01 of a 1bp paid on the premium leg. Calculating the RPV01 requires a model that uses market spreads to determine probability of default. Bloomberg – CDWS function

  49. Basket Default Swaps(or default baskets) • Synthetic correlation products that redistribute the risk of a portfolio of 5 to 200 CDS. • Similar to a CDS, except that the nth credit event is the trigger. The first-to-default (FTD) basket takes the first defaults. Protection seller receives a spread based on the notional value until the nth credit event or maturity.

  50. A basket default swap exposes the protection seller to the tendency of the assets to default together, or default correlation.

More Related