An Introduction to Credit Derivatives

Table of Contents

Cover image

Title page

Copyright

Dedication

About the Author

Foreword

Preface

Preface to the First Edition

Chapter 1. Credit Risk

1.1 The Concept of Synthetic Investment

1.2 Banks and Credit Risk Transfer

1.3 Credit Risk and Credit Ratings

1.4 Corporate Recovery Rates

Chapter 2. Credit Derivative Instruments: Part I

2.1 Credit Risk and Credit Derivatives

2.2 Credit Derivative Instruments

2.3 Credit Default Swaps

2.4 Asset swaps

2.5 Total Return Swaps

2.6 Index CDS: The iTraxx Index

2.7 Settlement

2.8 Risks in Credit Default Swaps

2.9 Impact of the 2007–2008 Financial Crash: New CDS Contracts and the CDS ‘Big Bang’

References

Appendices

Chapter 3. Credit Derivative Instruments: Part II

3.1 Credit-Linked Notes

3.2 CLNs and Structured Products

References

Chapter 4. Credit Derivatives: Basic Applications11Part of this chapter first appeared in Choudhry (2000).

4.1 Managing Credit Risk

4.2 Credit Derivatives and Relative Value Trading

4.3 Bond Valuation from CDS Prices: Bloomberg Screen VCDS

4.4 Relative Value Trading: Sovereign Names

4.5 Applications of Total Return Swaps

4.6 Applications for Portfolio Managers

Reference

Chapter 5. Credit Derivatives Pricing and Valuation

5.1 Introduction

5.2 Pricing Models

5.3 Credit Spread Modelling

5.4 Product Pricing Approach

5.5 Credit Curves

References

Chapter 6. Credit Default Swap Pricing

6.1 Theoretical Pricing Approach

6.2 Market Pricing Approach

6.3 Credit Derivatives Pricing in Volatile Environments: ‘Upfront+Constant Spread’

6.4 Quick CDS Calculator

References and Bibliography

Appendices

Chapter 7. The Asset Swap–Credit Default Swap Basis

7.1 Asset Swap Pricing

7.2 The Basis as Market Indicator

7.3 Analyzing the Basis Spread Measure

7.4 Market Observations

7.5 The iTraxx Index Basis

7.6 Negative Basis Trade: Checking the Theoretical Bond Price

References

Glossary

Index

Copyright

Butterworth-Heinemann is an imprint of Elsevier

The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK

225 Wyman Street, Waltham, MA 02451, USA

First edition published 1988

Second edition published 2013

© 2013, Moorad Choudhry and Elsevier Ltd. All rights reserved

The right of Moorad Choudhry to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988

No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England WIT 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher

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The views expressed in this book are an expression of the author’s personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this book and accepts no responsibility for any consequence of their use. This book does not constitute an offer or a solicitation of an offer with respect to any particular investment.

Whilst every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this book can be accepted by the author, publisher or any named person or corporate entity.

No part of this book constitutes investment advice and no part of this book should be construed as such. Neither the author nor the publisher or any named individual or entity is soliciting any action, response or trade in response to anything written in this book.

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ISBN: 978-0-08-098295-3

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Dedication

Dedicated to my wife, Lindsay Choudhry

The street of shame is a street of hacks

The men behind the men who do deals behind our backs

The fourth estate is a house of hate

Media pimps with scant regards for facts

They nail their victims with a telephoto to the ground

Feed the people on scraps of evil

And their daily diet – a plateful of hateful.

Private greed, not public need

Life’s geared to profit, money, wealth

They can’t get enough of it.

And in the papers the same old story

Every picture sells a Tory

Money, profit, wealth,

They can’t get enough of it,

Money, profit, wealth

Can’t get enough of it….

— Redskins, A Plateful of Hateful (King/Dean/Hewes)

from Neither Washington nor Moscow, London Records 1986

Reproduced with permission.

About the Author

Moorad Choudhry is Head of Treasury, Corporate Banking Division, at The Royal Bank of Scotland. He is Visiting Professor at the Department of Mathematical Sciences, Brunel University, and Visiting Teaching Fellow at the Department of Management, Birkbeck, University of London.

Moorad is a Fellow of the Chartered Institute for Securities & Investment and a Fellow of the ifs-School of Finance. He is on the Editorial Board of the Journal of Structured Finance and American Securitization, and is a member of the Board of Directors of PRMIA.

Foreword

We are witnessing one of the most important episodes in financial history. The situation started with the crisis in the US financial system, is now challenging the European Union project and will hopefully finish with some lessons learned and a more robust and efficient financial system.

Arguably, the start of this crisis goes further back in time with years of excess leverage in the private sector ignited by low interest rates and prodigious financial innovations. The failure by some agents to identify the risks associated with such leverage and the interconnectivity of a global financial community has resulted in the difficult economic environment we are now experiencing. Governments had to step in and assume the excesses of the private sector to contain the effects of a disordered asset reduction. The challenge is now of course the deleveraging of the public sector itself.

At the heart of this financial innovation were credit derivatives. Traditionally the concept of credit was intimately linked to funding. One could not get exposure to a company without lending to it either through a bond or a loan. The introduction of credit derivatives was particularly important as it enabled the transfer of credit risk without funding or a relationship with the issuer of the underlying credit.

A new world of possibilities was immediately created. Financial intermediaries could shape the risks of their portfolios through credit default swaps (CDS), buying and selling credit protection. Investors could have access to synthetically created customized products that fulfilled their requirements at virtually any time.

Credit worthiness was now truly an asset class of its own and credit derivatives expanded its applications as they transferred credit risk to counterparty risk. For lenders it is not only important to buy protection to offset the threat of default by a borrower, but it is equally important to assess the credit quality of the counterparty from whom the protection is bought, as well as the collateral terms. For instance, the examples of AIG and Lehman have demonstrated the importance of introducing counterparty value adjustments (CVA).

Much has been written about the role of credit derivatives in the development of the actual economic situation. In fact, a great part of what has been written condemns credit derivatives. But as with many other innovations in history, it is the usage and not the tool that creates the problems.

As over-the-counter (OTC) instruments, credit derivatives practitioners have been involved through different industry bodies, mainly the International Swaps and Derivatives Association (ISDA), in strengthening the documentation and making the liquidation process of defaults transparent, responding to challenges as they arose. This has been a good start and sets solid ground, but is not enough. Challenges remain to be addressed, such the concentration of the industry within a handful of counterparties, and the migration to central clearing counterparties (CCPs) to mitigate counterparty risk.

Policy makers have been busy preparing new regulations with the aim of implementing them as soon as possible hoping to avoid the mistakes of the past. Dodd-Frank, the Volcker Rule, BIS3 and CRD4, MiFID, Sovency II, among others, contain very plausible measures for financial institutions and insurers, but as the drafting of these rules is evolving a clear and timely implementation would be desirable to have a robust regulatory framework in the future.

It is therefore important to understand the credit product and have all the relevant information to be able to diligently get involved with credit derivatives. In this valuable book you will be able to learn about the theory, insights, usages and implications of credit derivatives.

Finally, we have now the possibility of reflecting on previous financial crises to understand how they eventually came to an end, and we have a unique opportunity to make sure that new such episodes are not repeated. Better information and a responsible application of financial innovation should guarantee an efficient flow of capital to help the development of prosperous and sustainable growth.

Juan Blasco

Head of Credit Products, Wholesale Banking and Marketing, Lloyds Bank Group

19 October 2012

Preface

Finance is a dry, unemotional subject. At least, it should be. Discussing any aspect of it should not be a cause for undue stress or argument. It isn’t as if one is debating abortion rights or the Arab–Israeli peace process when one enters into a conversation on financial products. Any discourse in this field should be logical and objective, aimed at arriving at a sound solution that meets the needs of the relevant stakeholders.

Sadly, in the era following the banking crash of 2008, when the US and a number of European governments had to spend a considerable sum of taxpayers’ money saving their banking sector, we encounter considerable subjective and emotional debate in finance. Some commentators have suggested that ‘CDOs’ caused the financial crash. Others, including some so-called ‘gurus’ best known for specific trades they may have undertaken over 20 years ago or who worked in banking over 30 years ago, have suggested that credit default swaps (CDS) caused the crash and should be banned to prevent the next crash.

This is utter nonsense. Financial instruments didn’t cause the crash any more than tulips caused the crash of 1637 or Gordon Gekko caused the crash of 1987. A number of factors, working in concert, combined to produce a market correction and what all crashes have in common is speculation, mis-pricing, greed, applying incorrect or inaccurate assumptions and an inept understanding of the basic principles of finance. For tulips we can substitute sub-prime mortgages, for example, but on its own a financial instrument does not cause a crash. If used in a certain way certain products may make it easier for the effects of mis-pricing to be transferred more quickly across the market, but of itself it is financially illiterate to suggest that CDOs or CDS caused the crash. To do so only reflects subjective and emotional thinking.

This book isn’t about the crash of 2008 or indeed any other crash. Rather, it is an introduction to a particular type of bank risk management product known as the credit derivative. The emergence of this product in the financial markets in the mid-1990s resulted in a repeat of the classic ‘tail wagging the dog’ scenario that one had observed in the 1980s, when interest-rate derivatives were introduced. Now the principal instrument used for valuation and analysis of the credit asset class is the credit default swap, just as interest-rate derivatives are now used as a benchmark for the interest-rate market, not the equivalent cash instruments.

In this book we introduce credit derivatives for the practitioner or graduate student in accessible fashion. The emphasis is on early understanding, and practical application. Those wishing to study the nuances of the product in greater detail may wish to consult the author’s book Structured Credit Products (John Wiley & Sons, 2010).

Layout of the book

This book is organized into seven chapters, as follows:

Credit Risk

Credit Derivatives I

Credit Derivatives II

Credit Derivatives Applications

Pricing

CDS Pricing

The Asset Swap–Credit Default Swap Basis

Comments on the text are welcome and should be sent to me care of Elsevier. I hope you enjoy reading the book and that it is of value to you.

Moorad Choudhry

Surrey, England

May 2012

Preface to the First Edition

A key risk run by investors in bonds or loans is credit risk, the risk that the bond or loan issuer will default on the debt. To meet the need of investors to hedge this risk, the market uses credit derivatives. These are financial instruments originally introduced to protect banks and other institutions against losses arising from default. As such, they are