RISK: CREDIT Lecture I
Lina El-Jahel 2006
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1.1
Introduction to Credit Derivatives
Default risk
Default risk is the risk that an obligor does not honour his payment obligations 1. linked to (every) individual payment obligation 2. linked to legal rules governing obligations 3. via legal rules: default risk of one payment obligation connected to other payment obligations of the same obligor Properties: 1. Default events are rare (high legal penalties). 2. They may occur unexpectedly. 3. Default events involve significant losses. 4. The size of these losses is unknown before default.
1.2
Components of Credit Risk
1. arrival risk 2. timing risk 3. recovery risk 4. market risk*, price correlation risk* 5. default correlation risk * must be consistent with other risks 1
1.3
Credit Derivatives
Credit Derivatives are derivative securities that are used to trade and hedge default risks. Usually, their payoff is made contingent on the occurrence of a Credit Event (e.g. a payment default or a bankruptcy). Credit Derivatives enable the user to trade the credit risk of an obligor in isolation, i.e. independently from the obligors bonds or loans.
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Credit Default Swap (CDS)
[Insert Figure 1 here] CDS Fee / Rate s: paid by A to B in compensation of default risk Default Payment: w.r.t. a reference asset issued by C. Alternatives are: A is the seller of the credit protection. B is the buyer of the credit protection and C is the reference obligor 1. Notional minus market value of the reference asset (cash settlement) 2. Notional for delivery of the reference asset (physical settlement) Effect of the CDS: Transfer of the C-default risk from B to A.
2.1
Documentation
Key terms: (negotiable, but standardised by ISDA) 1. notional, maturity, currency 2. CDS fee 3. reference entity (reference credit) -reference assets -deliverable obligations 4. credit event definitions 5. settlement method
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2.1.1
Notional, Maturity
Typical values 1. notional amount: 5-100m USD/EUR, median 10m 2. maturity: up to 10 years, most liquidity at 5 years 3. currency: usually USD or EUR 4. also note: -trade date -effective date: the date from which the transaction is valid (usually trade date + 3 business days) -scheduled termination date: fancy word for: maturity Example: 10m USD notional, 5 years to maturity.
2.1.2
CDS: Fees
1. The fee is the price of the default protection. Initially, it is chosen such that the CDS has initial value zero to both sides. 2. Fee payments are terminated at a credit event, but the accrued fee up to the credit event is paid. 3. Technical payment details -quoted as basis points of the notional of the CDS -payment in regular intervals (quarterly or semi-annually) -payment is made at the end of each interval -usual swap daycount conventions apply (e.g. act/360) Example: 168 bp
2.1.3
Quarterly Reference Credit / Reference Entity / Reference Obligor
The entity whose default risk is transferred. Potential problem scenarios: 1. Mergers, demergers 2. Takeovers 3. Spin-offs (successor-problem) 3
4. Conglomerates: Mother / daughter i.e.: If you buy protection on Ford Motor Co., are you protected against a default of Ford Motor Credit Co. (a 100% daughter) and vice versa? Example: Ford Motor Co. 2.1.4 Reference Assets
1. a set of bonds or other assets issued by the reference credit (RC). 2. Purpose: Determination of the credit event. 3. Usually a very broad definition: (up to owed money) 2.1.5 ISDA: 1. Bankruptcy (RC) 2. Failure to pay (RA) 3. Obligation default (RA) 4. Obligation acceleration (RA) 5. Repudiation / moratorium (RC) 6. Restructuring (RC) (controversial / must be negotiated) But also other definitions are possible: 1. industrial disruption (=strikes) 2. government action (=nationalisation) 3. armed hostilities (sovereigns) Notification of a credit event must be given (usually by the protection buyer). Credit Events
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2.1.6
Default Payment
Physical delivery: 1. protection buyer delivers deliverable obligations (notional = CDS notional) 2. protection seller pays CDS notional Protection buyer has a delivery option. Cash settlement: determination of recovery / loss in default: 1. calculation agent 2. dealer poll, repeated, averaging (elimination of highest and lowest) 3. protection seller pays [CDS notional] minus [recovery value]. 2.1.7 Effect:
1. speed: payment or delivery within 2-6 weeks after default event 2. independence of legal considerations and bankruptcy law 3. problems with market manipulation and liquidity/ short squeezes 4. physical delivery most common whenever possible 5. cash settlement for: credit-linked notes, etc. There is a lot of money in the default and the payment specifications! 2.1.8 Motivation, Advantages and Applications
-credit risk can be traded in isolation -no economic transfer of ownership -flexibility: specified to the needs of the counterparties -confidentiality (customer relations) -possibility to short credit risk -portfolio management or regulatory capital -Cost of funding advantages [Insert Figure 2 here] [Insert Figure 3 here] [Insert Figure 4 here] 5
2.2
Trading CDSs: Technicalities
1. Trading takes place: OTC, intra-bank, via brokers (e.g GFInet), some online exchanges (creditex, credittrade) 2. large investment banks as market makers (JPMorgan, Deutsche Bank, Lehman Brothers, Goldman etc...) 3. Bid/Ask convention: The traded asset is protection -Bid: What the broker bids if you him offer protection -Ask: What the broker asks for if you want to buy protection -Ask-Bid=12% of the price approximatively 4. Collateral/margin required from lower rated counterparties if they sell protection 5. Documentation (partially) standardised by ISDA. Price differences for documentation variations 6. Most liquid products: Single-Name CDS -documentation according to ISDA standard -5 year maturity -notional 10-100m -quarterly fee payments, USD or EUR -reference entity: large corporation, bond issuer
2.3
Asset Swap Packages
Eliminate interest-rate exposure from defaultable bonds (and isolate credit exposure). An asset swap package is a combination of: 1. a defaultable bond (the asset) 2. with an interest-rate swap contract The interest-rate swap swaps the coupon of the bond into a payoff stream of Libor plus a spread sA . This spread is chosen such that the value of the whole package is the par value of the defaultable bond. Usually, the bond is a fixed-coupon bond and the interest-rate swap a fixed-for-floating interest-rate swap.
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2.3.1
Payoffs Asset Swaps
A sells to B for 1 (the notional value of the C-bond): 1. a fixed coupon bond issued by C with coupon c payable at coupon dates Ti , i = 1, . . . , N 2. a fixed for floating swap (as below) The payments of the swap: At each coupon date Ti , i N of the bond 1. B pays to A: c, the amount of the fixed coupon of the bond, 2. A pays to B: Libor + sA . Problem: What to do with the interest-rate swap at a default event? [Insert figure 5 here] [Insert Figure 6 here]
2.4
Total Rate of Return Swaps TRS
1. Motivation: Completely exchange payoff streams / returns from two investments without legal transfer of ownership. 2. One investment is the defaultable bond, the other is default-free Libor. 3. To limit counterparty risk: Mark-to-Market at regular intervals. Similar to exchange-traded Futures contracts. 2.4.1 Payoffs
[Insert Figure 7 here] Counterparty A pays to counterparty B at regular intervals: 1. the coupon c of the bond issued by C (if there was one) 2. the price appreciation (C(Ti+1 ) - C(Ti ))+ of bond C since the last payment 3. the principal repayment of bond C (at the final payment date) 4. the recovery value of the bond (if there was a default)
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B pays at the same intervals 1. a regular fee of Libor + sT RS 2. the price depreciation (C(Ti ) - C(Ti+1 ))+ of the bond C since the last payment (if there was any) 3. the par value of the bond (if there was a default in the meantime) These payments are netted. 2.4.2 Effect of a TRS
1. The investor (TR receiver) assumes all risks and cash flow of the reference asset. 2. The bank (TR payer) passes through all payments of the RA. 3. The investor makes regular payments (akin to funding cost). 4. Mark-to-market: Regular exchange of payments reflecting price changes of the RA. 5. Allows counterparty B to leverage his position. 6. A has hedged his position if he owns the reference asset (but still faces coubterparty risk). 7. The transaction does not require the consent of C (bank keeps customer relationship) 8. if A doesn't own the reference asset he has created a short position in this asset 2.4.3 Problems with TRS:
dependence on a single reference asset: 1. default risk only of this one asset 2. generally not enough flexibility 3. but a frequent and useful tool in more complex structures Potential Problem: Representation in case of default and information disadvantage of TR receiver vs. loan originator. 8
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3.1
Other Single-Name Credit Derivatives
Default Digital Swaps
Like CDS, but: 1. Default Payment = 1 2. no recovery / Loss In the Event of Default (LIED) determination Motivations: 1. avoid complicated settlement 2. exposure not related to LIED 3. bet on recovery rate 3.1.1 Recovery-Rate Bets
1. A long position in a CDS with notional of 1: Fee: s Payoff in default: 1 - Recovery. 2. a long position in a DDS with notional of s/DDS : s DDS DDS Fee: s/ s s =s Payoff in default: s/DDS . s Same fee payments before default. Therefore, the payoffs in default must be equally valuable, too. This means that the implied recovery rate is Recovery impl = 1 - s sDDS (1)
3.2
Credit Spread Options
Possible variations: 1. Options on CDS: Option to enter a CDS at a given time and for a given CDS spread. Enter as protection buyer: Call option. Enter as protection seller: Put option. 2. Option to extend / cancel an existing CDS. (As above.) 3. Options on Asset swap packages: Option to buy/sell a defaultable bond in form of an asset swap package for a given asset swap spread. 9
4. Yield spread options: Option to buy/sell a bond at a given yield spread over a pre-specified benchmark bond (unusual). 5. Plain bond option: Option to buy/sell a defaultable bond for a given price. (Also carries interest-rate risk.) 6. Motivation -insure against adverse credit spread moves while keeping the upside.
3.3
Credit-Linked Notes
Basic Note : 1. Coupon: LIBOR + Spread 2. Principal redeemed at maturity. 3. Issuer high credit quality (AAA-rated Special Purpose Vehicle) 4. Reference Credit (RC) and Reference Asset (RA) are defined. Example: Wal-Mart Credit Linked Note, Issuer: JP Morgan, September 1996 (via a AAA trust) Buyers receive: 1. coupon (fixed or floating) 2. principal if no default of reference (Wal-Mart) until T 3. recovery rate if there was a default. Default Risk: buyers equivalent to debt issued by Wal-Mart.
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