Credit Derivatives

Chapter 29

Credit Derivatives

credit risk in non-Treasury securities developed derivative securities that provide protection

against credit risk types

asset swaps total return swaps credit default swaps credit spread options credit spread forwards

structured credit products synthetic CDOs credit-linked notes

Credit Derivatives

types of credit risk default risk credit spread risk downgrade risk

categories of credit derivatives

Credit Derivative Terminology reference entity (reference issuer) reference obligation (reference asset) credit event

bankruptcy credit event upon merger cross acceleration cross default downgrade failure to pay repudiation/moratorium restructuring

Asset Swaps

example investor purchases $10m par of 7.85%, 5 year bond of

BBB-rated firm at par with semiannual coupons investor enters into 5 year swap where he is fixed rate

payer with semiannual payments – pays 7.0% and gets 6 month LIBOR

investor earns 85bp over LIBOR if no default investor has created synthetic floating-rate bond

Total Return Swap

swap where one party makes periodic floating-rate payments to counterparty in exchange for the total return realized on a reference obligation total return index swap total return receiver – exposed to credit and

interest rate risk total return payer

Total Return Swap Example

portfolio manager thinks Izzo’s fortunes will improve and credit spread relative to Treasury will decline over next year

used to increase exposure to reference obligation Izzo issued 10 year bond at par with 9% coupon when Treasury is 6.2%

- credit spread to Treasury? what can manager do if she believes spread declines?

total return swap as receiver with reference obligation of Izzo bond issue – semiannual payments – receiver pays 6 month Treasury + 160bp – notional $10m

over one year 6 month Treasury starts at 4.8% rate for computing second semiannual payment is 5.4% at the end of year 1, 9 year Treasury rate is 7.6% at the end of year 1, credit spread for reference obligation is 180bp

Total Return Swap Example

first swap payment is 3.2% (4.8% + 160bp divided by 2) * notional

second swap payment is 3.5% (5.4% + 160bp divided by 2) * notional

payments received by manager are coupon payment (9%*10m) and change in value of reference obligation which will sell to yield (7.6% + 180=9.4%) - find price of this bond

portfolio manager must make paymentof $9,000

Total Return Swaps

benefits receiver does not have to finance purchase of reference

assets receiver can get same economic exposure to diversified

basket of assets in one swap transaction that would otherwise take several cash market transactions

investor can use total return swap to short a corporate bond – action that is otherwise difficult

disadvantage return to receiver is dependent on both credit risk (declining

or increasing credit spreads) and market risk (declining or increasing market rates) credit-independent market risk credit-dependent market risk

Credit Default Swaps

most commonly used stand-alone product of group simplest form so others (credit default options) rarely used

used to shift credit exposure to a credit protection seller purpose is to hedge credit exposure to a specific asset or

issuer single name credit default swap basket credit default swap credit default swap index

buyer pays fee to protection seller in return for right to receive payment conditional upon occurrence of credit event by reference obligation or reference entity protection seller must pay if credit event occurs

Credit Default Swaps

interdealer market for single-name credit default swaps swaps for corporate and sovereign entities are

standardized some custom agreements typically 5 years

settlement cash or physical delivery

payment by protection seller – predetermined or based on change in value of reference obligation amount of payment can be set or may be determined after

credit event

Single-Name Credit Default Swaps reference entity is XYZ Corp. and underlying is $10m par of XYZ

bonds swap premium is 200bp – calls for quarterly payment of premium

quarterly payment determined using day count convention of actual/360

assume there are 92 days in quarter and premium is 200bp on $10m

if no credit event, protection buyer makes quarterly payments over life of swap – if credit event occurs: no more payments of swap premium by protection buyer to seller termination value is determined for swap – with physical settlement there are

issues called deliverable obligations

Single-Name Credit Default Swaps

Single-Name Credit Default Swaps uses by portfolio managers:

obtain exposure to reference entity using swap market instead of cash market because more liquid do this by selling protection and receiving a swap premium

difficult to sell currently held bond that has credit concern buy protection in swap market

if manager believes issuer will soon have trouble, shorting bond would be best but hard to short bond enter into swap as protection buyer

manager who wants a leveraged position in a corporate bond economically, a position of a protection buyer is equal to

leveraged position in corporate bond

Basket Credit Default Swaps

must specify when a payment needs to be made because they can be structured different ways first-to-default basket swap second-to-default basket swap

cash settlement most common

Credit Default Swap Index

credit risk of standardized basket of reference entities is transferred

swap premium is paid but if credit event occurs, the swap premium payment continues but amount of payment is reduced (because notional amount of reference entity is reduced)

uses by portfolio manager help adjust exposure to a credit sector of bond market index

increase exposure to credit sector by entering as protection seller

decrease exposure by entering as protection buyer