Business F723

1. Business F723 Fixed Income Analysis Week 12 Credit Derivatives and Review

2. Credit Derivatives • Similar to the way interest rate derivatives allow the transfer of some of the interest rate risk, credit derivatives allow an investor to transfer credit risk to others • These derivatives are often more efficient to use than actual cash market postions

3. Types of Credit Risk • Default risk • the issuer of the security fails to make the promised payments • Credit spread risk • due to a credit upgrade or downgrade, the required yield spread over treasury changes, affecting the price of the bond

4. ISDA • International Swap and Derivatives Association • Since 1998 has set standard contracts for credit default swaps and total return swaps • The contracts are flexible enough to use for the other derivatives listed

5. References • The contracts are based on some underlying security, referred to as: • reference entity or reference issuer; the firm that issued the bond and who’s credit risk is being transferred • reference obligation or reference asset; the particular bond issue (or other debt instrument) that is being protected

6. Credit Events • Many of the derivatives pay off when a particular event happens • Bankruptcy • Failure to pay • Obligation acceleration; the firm violates a term in the covenant making the bond due & payable • Repudiation/moratorium; rejecting the above • Restructuring; controversial, see next slide

7. Restructuring • Prior to seeking bankruptcy protection, a debtor can make a proposal to creditors or seek a restructuring of their debt • Problematic due to the discretion of the holders of the debt to accept the proposal • IDSA form has 4 different methods of handling restructuring in the contract • none, all, modified and modified modified

8. Asset Swap • Not strictly a credit derivative since credit risk is not traded • Own a bond paying fixed coupons, enter a swap agreement to trade fixed for floating payments • Sell the asset to a dealer with a swap agreement and an obligation to buy back the bond if there is a credit event

9. Total Return Swap • A swap agreement where one party makes floating rate payments and the counter party makes payments based on the total return (interest and capital gain/loss) of the reference obligation • Cash flow of the total return payer is similar to short selling the reference obligation and investing the proceeds

10. Credit Default Swap • Buyer pays a premium (a % of the notional amount), on a quarterly basis, to protect against default • In the event of a credit event, the seller of the swap buys the underlying asset from the buyer for the notional amount • Can be based on a basket of assets

11. Credit Spread Options • Underlying is a reference obligation • a call or put option where the strike price is not fixed but based on a fixed spread over treasury • Underlying is the credit spread • a cash settlement contract where the payoff is based on the difference between the reference obligation’s credit spread vs. the strike spreadx notional amount x risk factor

12. Credit Spread Forwards • Similar to the difference between forward contracts and option contracts on any other commodity • Related to a credit spread option, but the final settlement is not based on one party having the choice to exercise, so no option premium is required

13. Structured Credit Products • Debt instruments with payoffs linked to the credit performance of reference obligations • Synthetic CDO: Invests in low risk assets and sells credit protection derivatives • Dominates the CDO market • Credit-linked notes: short term debt, 1 - 3 years; if the reference asset defaults the note is paid off early and at a discount

14. Rapid Review

15. Call Protection • Most commercial mortgages do not allow free prepayments • Prepayment lockout • Defeasance • Prepayment penalty points • Yield maintenance charges

16. Balloons • Commercial mortgages typically have a balloon maturity provision • Lender may allow an extension if the borrower has difficulty refinancing, but charge a higher default interest rate • The possibility of default on the balloon payment is called balloon risk and, with the above provision can be a form of extension risk

17. Services • Can have a single servicer or multiple • Sub-servicer; collects cash and information • Master servicer; oversees the deal, verifies details of the agreement, makes timely payment of interest and principal (even when there are late payments) • Special servicer; deals with accounts more than 60 days overdue

18. Credit Enhancement • As with MBS, asset backed securities often include credit enhancement to get the credit rating the issuer desires • External enhancement; insurance, corporate guarantees, letters of credit • Internal enhancement; reserve funds, over-collateralization, senior/subordinated structure

19. Static Spread • Find the treasury spot rate term structure using the bootstrapping method • Find the present value of the cash flows for the bond using the spot rate plus a spread • Solve for the spread that gives the current price • Called the static or zero volatility spread

20. Negative Convexity • The normal price/yield curve is convex • With price compression the level of convexity can become negative (technically it is now concave) • Price change from increasing interest rates becomes larger than the change from falling interest rates

21. Interest Rate Volatility • The major influence on the price of a bond is interest rates • Changes in interest rates can be measured over time and the volatility can be estimated • Can be used to create an interest rate model • Textbook model is single factor, lognormal random walk, binomial interest ladder or lattice, estimating potential forward rates

22. Convertible Bonds • Another type of embedded option • A call option on a number of the issuer’s common share where the exercise price is the bond, regardless of current market value • Number of shares is conversion ratio • Can be physical or cash settle • Exchangeable bonds are similar options, but on other company’s shares

23. Minimum Price • The bond will trade at a minimum of the greater of the conversion value or straight (debt) value • conversion value: how much the stock that the bond can be converted to is worth • straight value: the value of the convertible if it did not have the conversion option

24. Market Conversion Prices • Since the exercise price is the bond, the effective price of the common stock changes over time

25. Jargon • A convertible where the option is well out of the money is called a bond equivalent or busted convertible • A convertible with a conversion value much higher than its straight value is called an equity equivalent • Between those it is a hybrid security

26. Options Approach • Similar to callable bonds, convertibles can be viewed as a bond and an option • An additional problem here is that the exercise price on the share changes over time as the bond’s market price is affected by changes in interest rates • To make matters worse, most convertible bonds are also callable

27. Futures • Similar to a forward contract in the fact that it binds both parties to a specific transaction in the future… but • A futures contract is standardized with respect to the quantity, quality, time, and location • Contracts are traded on organized exchanges • No specific link between the buyer and seller • Gains or losses are realized on a daily basis

28. T-Bill Quotes • T-bills are quoted on the annualized yield on a bank discount basis

29. T-Bill Futures Prices • Quoted on an index basisindex price = 100 - (Ydx 100) • Given a current quote of 3.75% for T-bills index price = 100 - (3.75) = $96.25 • Given a futures price of $92.50 the yield is

30. Invoice Price • This is how much is paid for the t-bill if it is delivered • Invoice price = $1,000,000 - D • Find the invoice price if the final settlement price is $92.50

31. Treasury Bond Futures Details • Price quoted per $100 of face value • Price quoted in $1/3296-13 means $(96 + 13/32) = $96.40625 • Invoice price = Contract size (face value/100)x settlement pricex conversion factor + accrued interest

32. Cheapest to Deliver • Given a choice sellers will want to figure out which issue is the cheapest to deliver • Face value of issue is set at $100,000 but actual price is affected by conversion ratio • Find implied repo rate • Highest repo rate is the cheapest to deliver

33. Theoretical Price • Assuming short sales, we can also do the reverse, so we can get a theoretical price • profit = 0 = proceeds - outlay • F = P(1 + t(r - c))F = futures price P = Current bond pricet = time to delivery r = financing costc = current yield on underlying bond • (r - c) called cost of carry

34. Option Basics • Options are based on buying or selling an asset in the future at a fixed price • This transaction is not guaranteed to take place • With an option one party to the option decides whether or not the transaction will be completed on the specified date

35. Option Basics • The option has given one party the right but not an obligation to buy or sell the asset at the fixed price • As you might guess, this party has to pay the other party for this privilege • The payment is called the option premium

36. Call Option Price

37. Futures Options • The right to enter into a futures contract at a pre-specified price • Call option: the right to take a long position • Put option: the right to take a short position • If exercised, the futures contract is written at the specified price, and immediately marked to market by the exchange

38. Interest Rate Swaps • Main idea is to trade fixed rate interest payments (receipts) for floating rate payments (receipts) • Swaps have counterparty risks since they are not traded on organized exchanges • May involve a securities firm or commercial bank as a broker or dealer

39. Interpreting a Swap • There are 2 ways of looking at a swap • A package of forward contracts • A package of cash market instruments • Buy a 9% fixed coupon $50m bond • Finance by borrowing $50 at LIBOR

40. Beyond Plain Vanilla • Varying principal swaps: the principal on which interest is calculated changes over time… often for amortizing securities • Basis swaps: exchanging floating rate payments based on different reference rates • Constant Maturity Swap: one of the reference rates is the constant maturity treasury (CMT) rate published by the federal reserve

41. Beyond Plain Vanilla • Swaptions: an option to enter into a swap contract at a point in the future • Forward start swap: a swap contract were the start date of the swap is in the future

42. Caps and Floors • Interest rate agreements include • The reference rate • The strike rate (cap or floor) • The length of the agreement • The frequency of settlement • The notional principal