Credit Derivatives - FINC 782 Energy Risk Management AB...

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Credit Derivatives FINC 782: Energy Risk Management AB Freeman School of Business, Tulane University, New Orleans, Fall 2007 Leslie McNew Email at [email protected] 865-5036
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1 Growth in Credit Derivatives Market British Bankers Association Survey Credit Derivatives (US $ Billions) 0 100 200 300 400 500 600 700 800 US $ bn 1996 2000 1999 1998 1997
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2 Growth in Credit Derivatives Market Credit Derivatives Newest of the derivative markets Developed around 1992-1993 Used to manage and exploit risks/opportunities in credit markets Risk transferred among participants----off or on balance sheet transactions Off balance-sheet On balance-sheet Credit default swaps credit linked notes total rate of return swaps CDO's (collateralised debt obligations)
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3 Growth in Credit Derivatives Market London is the dominant financial center Size of the international debt market A market-friendly regulatory environment Liquid asset swap market Derivative strengths
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4 Definitions Credit Derivative: a credit derivative allows the holder to isolate and separate credit risk from market risk, thus allowing this credit risk to be either hedged, traded, or transferred. A premium may be due. Credit Default Swap: enables isolation and transfer of credit risk without transferring ownership of the asset Digital Derivative: cash settled transaction (does not need delivery of underlying asset upon settlement) Total Return Swap: transfer credit risk by swapping an underlying asset’s specified total return (capital growth and interest) between two counterparties, in return for regular payments of LIBOR + spread LIBOR: the London inter-bank offer rate. The inter-bank rate used when one bank borrows from another. It is also the benchmark used to price many capital market and derivative transactions. Credit Spread: difference in ‘yields’ between an agreed reference rate and a specific asset in question. London: gilt market US: treasury market Off-balance sheet: instrument or trade does not have to be admitted to the firm’s balance sheet (can be ‘hidden’)
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5 Credit Derivative ‘Trigger’ Events Payment default or bankruptcy/insolvency in the case of corporate credits Moratorium on payments or the rescheduling of payments, as well as payment default itself, for sovereign credits Chapter 11 or bankruptcy filing by the issuer failure to meet payment obligations when due rating downgrade below an agreed upon level change in the agreed credit spread (over a government bond or compared to another government bond) A materiality threshold (a significant price decline) has also to be breached and independently agreed.
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6 Fee Determinants for Credit Derivatives credit rating or probable swap counterparty maturity probability of default expected value of the asset (post-default) assumed mark to market risk of per counterparty: $10,000,000 Porfolio Simulation Name Ticker Ratings Industry 1 yr offer Pricing Duke Energy Corp DUK A utility 82 $82,000 American Electric Power AEP A utility 80 $80,000 Sempra Energy SRE A utility 570 $570,000
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