lecture1 - CREDIT RISK: Lecture I Lina El-Jahel 2006 1...

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Unformatted text preview: CREDIT RISK: Lecture I Lina El-Jahel 2006 1 Introduction to Credit Derivatives 1.1 Default risk Default risk is the risk that an obligor does not honour his payment obliga- tions 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. 2 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 2 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....
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lecture1 - CREDIT RISK: Lecture I Lina El-Jahel 2006 1...

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