Credit Derivatives:

By Vinod Kothari [Vinod Kothari’s Credit Derivative website: www.credit-deriv.com]

The development of credit derivatives is a logical extension of two of the most significant
developments of our present times: securitization, and derivatives. The concept of derivative
is to create a contract that derives from an original contract or asset. For example, stock
market derivatives are contracts that are settled based on movements in prices of stocks,
without transferring the underlying stock. Similarly, a credit derivative is a contract that
involves a contract between parties in relation to the returns from a credit asset, without
transferring the asset as such.

What is a credit derivative?

A credit asset is the extension of credit in some form: normally a loan, installment credit or
financial lease contract.

Every credit asset is a bundle of risks and returns: every credit asset is acquired to make
certain returns on the asset, and the probability of not making the expected return is the risk
inherent in a credit asset.

There are several reasons due to which a credit asset may not end up giving the expected
return to the holder: delinquency, default, losses, foreclosure, prepayment, interest rate
movements, exchange rate movements, etc.

A credit derivative contract intends to transfer the risk of the total return in a credit
transaction falling below a stipulated rate, without transferring the underlying asset. For
example, if bank A enters into a credit derivative with bank B relating to the former's
portfolio, bank B bears the risk, of course for a fee, inherent in the portfolio held by bank A,
while bank A continues to hold the portfolio.

The motivation to enter into credit derivatives transactions are well appreciable. In part, it is a
design by a credit institution, say a bank, to diversify its portfolio risks without diversifying
the inherent portfolio itself. In part, the trend towards credit derivatives has been motivated by
bankers' need to meet their capital adequacy requirements.

Let us visualise a bank, say Bank A which has specialised itself in lending to the office
equipment segment. Out of experience of years, this bank has acquired a specialised
knowledge of the equipment industry. There is another bank, Bank B, which is, say,
specialised in the cotton textiles industry. Both these banks are specialised in their own
segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in the
office equipment segment and bank B is focused on the textiles segment. Understandably,
both the banks should diversify their portfolios to be safer.

One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say
textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office
equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know
enough of the textiles segment as bank A does not know anything of the office equipment
segment.

Here, credit derivatives offer an easy solution: both the banks, without transferring their
portfolio or reducing their portfolio concentration, could buy into the risks of each other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a
fee. Both continue to hold their portfolios, but both are now diversified. Both have diversified

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their risks. And both have also diversified their returns, as the fees being earned by the
derivative contract is a return from the portfolio held by the other bank.

The above example has depicted credit derivatives being a bilateral transaction - as a sort of a
bartering of risks. As a matter of fact, credit derivatives can be completely marketable
contracts: the credit risk inherent in a portfolio can be securitised and sold in the capital
market just like any other capital market security. So, any one who buys such a security is
inherently buying a fragment of the risk inherent in the portfolio, and the buyers of such
securities are buying a fraction of the risks and returns of a portfolio held by the originating
bank.

Thus, the concept of derivatives and securitisation have joined together to make risk a
tradable commodity.

A definition of credit derivatives:

Credit derivatives can be defined as arrangements that allow one party (protection buyer or
originator) to transfer credit risk of a reference asset, which it may or may not own, to one or
more other parties (the protection sellers).

Types of credit derivatives:

The easiest and the most traditional form of a credit derivative is a guarantee. Financial
guarantees have existed for thousands of years. However, the present day concept of credit
derivatives has traveled much farther than a simple bank guarantee. The credit derivatives
being currently used in the market can be broadly classified into the following:

Total return swap:

As the name implies, a total return swap is a swap of the total return out of a credit asset
against a contracted prefixed return. The total return out of a credit asset can be affected by
various factors, some of which may be quite extraneous to the asset in question, such as
interest rate movements, exchange rate fluctuations etc. Nevertheless, the protection seller
here guarantees a prefixed return to the originator, who in turn, agrees to pass on the entire
collections from the credit asset to the protection seller. That is to say, the protection buyer
swaps the total return from a credit asset for a predetermined, prefixed return.

Credit default swap:

Credit default swap is a refined form of a traditional financial guarantee, with the difference
that a credit swap need not be limited to compensation upon an actual default but might even
even cover events such as downgrading, apprehended default etc. In a credit default swap, the
protection seller agrees, for an upfront or continuing premium or fee, to compensate the
protection buyer upon the happening of a specified event, such as a default, downgrading of
the obligor, apprehended default etc. Credit default swap covers only the credit risk inherent
in the asset, while risks on account of other factors such as interest rate movements remains
with the originator.

Credit linked notes:

Credit linked notes are a securitized form of credit derivatives. The technology of
securitisation here has been borrowed from the catastrophe bonds or risk securitization
instruments. Here, the protection buyer issues notes. The investor who buys the notes has to
suffer either a delay in repayment or has to forego interest, if a specified credit event, say,
default or bankruptcy, takes place. This device also transfers merely the credit risk and not
other risks involved with the credit asset.

Credit derivatives are derivative instruments that seek to trade in credit risks. All derivatives
have some common features: they are related to some risk or volatility, typically do not
require initial investment, and may be net settled. For example, the risk or volatility in an

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inter-rate swap is movements in interest rates. In a commodity derivative, it is commodity
prices. Likewise, the subject matter of a credit derivative is the general credit risk of a
reference entity. The general credit risk is indicated by the happening of certain events, called
credit events, which include bankruptcy, failure to pay, restructuring etc.

There is a party trying to transfer credit risk, called protection buyer, and the counterparty is
trying to acquire credit risk, called protection seller.

The primary purpose of credit derivatives must have been to hedge - a bank having exposure
in a reference entity seeks to protect itself by buying protection from another. But over time,
credit derivatives market has become a trading market. Trades in credit derivatives are taken
to be proxies for trades in actual loans or bonds of the reference entity. For example, a bank
willing to acquire exposure in a reference entity X would sell protection referenced to X;
while a bank holding a bearish view on X will buy protection. Therefore, credit derivatives
trades have become easy tools to replicate a funded cash bond or cash loan of a reference
entity, minus all the inflexibilities, lack of availability or regulatory and geographical barriers.

Credit derivatives are typically unfunded - the protection seller is not required to put in any
money upfront. The protection buyer typically pays a periodic premium. However, the credit
derivative may be funded as well - for example, the protection buyer may require the
protection buyer to pre-pay the entire notional value of the contract upfront. In return, the
protection buyer may issue a note, called credit linked note. The credit linked note is similar
to any other bond or note, with the difference that from the amount due for repayment, the
protection buyer (issuer) may deduct the amount of payments, if any, required on account of
credit events.
A credit derivative being a derivative, does not require either of the parties - the protection
seller or protection buyer - to actually hold the reference asset. Thus, a bank may buy
protection for an exposure it has, or does not have, or irrespective of the amount or term for
which it has actual exposure. Obviously, therefore, the amount of compensation that can be
claimed under a credit derivative is not related to the actual losses suffered by the protection
buyer.

When a credit event takes place, there are two ways of settlement - cash and physical. Cash
settlement means the reference asset will be valued, and the difference between its par and
fair value will be paid by the protection seller. Physical settlement means the protection seller
will acquire the defaulted asset, for its full par.

Based on the type of risk being transferred, credit derivatives may be broadly classed in
• credit default swaps
• total rate of return swaps
• equity default swaps

In a credit default swap, the protection buyer continues to pay a certain premium to the
protection seller, with the option to put the credit to the protection seller should there be a
credit event. Unless there is a credit event, there is no exchange of the actual asset or the
cashflows arising out of the actual asset.

In a total rate of return swaps, the parties agree to exchange the actual cashflows from the
asset (say a bond), including the appreciation and depreciation in its market value,
periodically, with returns referenced to a certain reference rate. Say, the reference rate is
LIBOR. The protection buyer will get LIBOR + x bps, and pay over to protection seller all he
earns from the reference assets. Thus, he replaces the returns from the reference asset by a
return calculated on a reference rate - thereby transferring both the credit risk as well as the
price risk of the reference asset.

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Equity default swaps, relatively new in the marketplace, use a substantial and non-transient
decline in the market value of equity as a trigger event - assuming that a deep decline in the
market value of equity is either indicative of a default or preparatory for a default.

Credit linked notes package a credit default swap into a tradable instrument - a note or a
bond. The credit linked notes may be issued either by the protection buyer himself or by a
special purpose vehicle.

A credit derivative may be reference to a single reference entity, or a portfolio of

reference entities - accordingly it is called single name credit derivative, or portfolio credit
derivative. In a portfolio derivative, the protection seller is exposed to the risk of one or more
constituents in the portfolio, to the extent of the notional value of the transaction.

A variant of a portfolio trade is a basket default swap. In a basket default swap, there would
be a bunch of names, usually equally weighted (say with a notional value of USD 10 million
each). The swap might be, say, for first to default in the basket. The protection seller sells
protection on the whole basket, but once there is one default in the basket, the transaction is
settled and closed.

If the names in the basket are uncorrelated, this allows the protection seller to leverage
himself - his losses are limited to only one default but he actually takes exposure on all the
names in the basket. And for the protection seller, assuming the probability of the second
default in a basket is quite low, he actually buys protection for the entire basket but paying a
price which is much lower than the sum of individual prices in the basket.

Likewise, there might be a second-to-default or n-th to default basket swaps.

Evolution of credit derivatives

Many people claim that credit derivatives evolved in 1995, but they are wrong. Credit
derivatives emerged in early 1993 or even before that. In March 1993, Global Finance
carried an article which said that three Wall Street firms - J. P. Morgan, Merrill Lynch, and
Bankers Trust - were already then marketing some form of credit derivatives. Prophetically,
this article also said that credit derivatives could, within a few years, rival the $4-trillion
market for interest rate swaps. In retrospect, we know that this was right.

Not only were credit derivatives already a topic frequently talked about in financial press in
1993, they initially faced a bit of resistance. In Nov. 1993, Investment Dealers Digest
carried an article titled Derivatives pros snubbed on latest exotic product which claimed that a
number of private credit derivative deals had been seen in the market but it was doubted if
they were ever completed.

The article also said that Standard and Poor's had refused to rate credit derivative products
and this refusal may put a permanent damper on the fledgling market. S&P seems to have
issued some kind of a document which said that in essence, these securities represent a bet by
the investor that none of the corporate issuers in the reference group will default or go
bankrupt.
One commentator quoted in the said article said: "It (credit derivatives) is like Russian
roulette. It doesn't make a difference if there's only one bullet: If you get it you die".

Almost 3 years later, Euromoney reported [March 1996: Credit derivatives get cracking ]
that a lot of credit derivatives deals were already happening. From a product that was branded
as a "touted" product in 1993, the market perception had changed into one of unbridled
optimism. The article said: "The potential of credit derivatives is immense. There are
hundreds of possible applications: for commercial banks which want to change the risk profile

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of their loan books; for investment banks managing huge bond and derivatives portfolios; for
manufacturing companies over-exposed to a single customer; for equity investors in project
finance deals with unacceptable sovereign risk; for institutional investors that have unusual
risk appetites (or just want to speculate); even for employees worried about the safety of their
deferred remuneration. The potential uses are so widespread that some market participants
argue that credit derivatives could eventually outstrip all other derivative products in size and
importance."

Here are some significant milestones in the development of credit derivatives:

• 1992 - Credit derivatives emerge. Isda first uses the term "credit derivatives" to
describe a new, exotic type of over-the-counter contract.
• 1993 -KMV introduces the first version of its Portfolio Manager model, the first
credit portfolio model.
• 1994 - Credit derivatives market begins to evolve. There are doubts expressed by
some - as above.
• September 1996 - The first CLO of UK's National Westminster Bank.
• April 1997 - J P Morgan launches CreditMetrics
• October 1997 - Credit Suisse launches CreditRisk+
• December 1997 - The first synthetic securitisation, JP Morgan's Bistro deal.
• July 1999 - Credit derivative definitions issued by Isda.

A synthetic CDO in terms of structure is no different from a usual collateralized debt

obligation (CDO). A CDO is a device whereby a portfolio of loans or other debt obligations
are transferred to a vehicle (the CDO SPV) which raises liabilities to finance such assets, in a
manner that the repayment of the liabilities is solely collateralized by the portfolio of loans or
debts. In other words, a CDO is a process of securitising a portfolio of loans or debt
obligations.

CDOs are the fastest growing segment of the securitisation market. CDOs are classed into
cash or synthetic CDOs, based on the nature of their assets. If the assets are acquired for cash,
the CDO is a cash CDO. However, if the CDO acquires primarily synthetic assets by selling
protection rather than buying assets for cash, it is a synthetic CDO.

Evidently, the amount of funding required for a synthetic CDO is much lesser than that of a
cash CDO. The amount of cash raised is limited only to the extent of expected and
unexpected losses in the portfolio of synthetic assets, such that the highest of the cash
liabilities can get a AAA rating. Once a AAA-rating is obtained for the senior-most cash
liability, a synthetic CDO does not raise more cash - it merely raises a synthetic "liability" by
buying protection from a super-senior swap provider.

ISDA Credit Event definitions

The 1999 Definitions have been replaced by 2003 Definitions.

ISDA Credit Event definitions are a part of 1999 Credit Derivative Definitions. The 1999
Definitions are standard industry terms which are usually incorporated by contracting parties
in their swap agreements.

The 6 Credit Events under ISDA Definitions are:

1. Bankruptcy
2. Obligation Acceleration
3. Obligation Default
4. Failure to Pay
5. Repudiation/Moratorium

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 6. Restructuring

A. CREDIT EVENTS
1. Bankruptcy
Bankruptcy in the 1999 Definitions mirrors the wording of Section 5(a)(vii) of the ISDA
Master Agreement. It is widely drafted so as to be triggered by a variety of events associated
with bankruptcy or insolvency proceedings under English law and New York law, as well as
analogous events under other insolvency laws.

ISDA is aware that the scope of the definition of Bankruptcy may be wider than insolvency-
related events falling within the credit assessment criteria used by rating agencies. Certain
actions taken by the reference entity, for instance, a board meeting or a meeting of
shareholders to consider the filing of a liquidation petition, could be argued as being in
furtherance of an act of bankruptcy and thus triggering a Credit Event, even though such act
would not generally be considered a bankruptcy event in the context of credit assessment by a
rating agency. Therefore, the inclusion of this Credit Event could provide credit protection
ahead of such circumstances.

By contrast, a guarantee would not typically provide any protection against insolvency-related
events ahead of an actual failure to pay.

2. Obligation Acceleration
Obligation Acceleration covers the situation, other than a Failure to Pay, where the relevant
obligation becomes due and payable as a result of a default by the reference entity before the
time when such obligation would otherwise have been due and payable. The Default
Requirement builds in a minimum threshold which the relevant sum being accelerated must
exceed before the Credit Event occurs.

The scope of this Credit Event forms a subset of that of Obligation Default. Thus if
Obligation Default is specified as a Credit Event in the relevant credit derivatives transaction,
this Credit Event will only be of relevance if the Default Requirement is lower than that in
respect of the Obligation Default.
The credit considerations are discussed under Obligation Default below.

3. Obligation Default
Obligation Default covers the situation, other than a Failure to Pay, where the relevant
obligation becomes capable of being declared due and payable as a result of a default by the
reference entity before the time when such obligation would otherwise have been capable of
being so declared. The Default Requirement builds in a minimum threshold which the
relevant sum being defaulted or capable of being accelerated must exceed before the Credit
Event occurs.

It may be important to note that the concept of "default" used in the present context refers to a
default under the relevant provisions of the relevant contract or agreement.

4. Failure to Pay
Failure to Pay is defined to be a failure of the reference entity to make, when and where due,
any payments under one or more obligations. Grace periods for payment are taken into
account.
The failure of payment is critical to the credit risk borne by a protection buyer under a credit
derivative product. A failure to pay by an underlying reference entity also encompasses the
situations in which guarantee payments are generally triggered.

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5. Repudiation/Moratorium
Repudiation/Moratorium deals with the situation where the reference entity or a governmental
authority disaffirms, disclaims or otherwise challenges the validity of the relevant obligation.
A default requirement threshold is specified.

6. Restructuring
Restructuring covers events as a result of which the terms, as agreed by the reference entity or
governmental authority and the holders of the relevant obligation, governing the relevant
obligation have become less favourable to the holders that they would otherwise have been.
These events include a reduction in the principal amount or interest payable under the
obligation, a postponement of payment, a change in ranking in priority of payment or any
other composition of payment. A default threshold amount can be specified.

This approach purports to adopt an objective approach by identifying specific events that are
typical elements of a restructuring of indebtedness. As restructuring events could be those
undertaken by a reference entity that would result in the credit quality being improved or
remaining the same, the Credit Event under the 1999 Definitions is specified not to occur in
circumstances where the relevant event does not result from a deterioration in the
creditworthiness or financial condition of the reference entity.

BIS II proposals on credit derivatives based on final version released June 2004

The BIS has issued the 3rd (and possibly the final) consultative paper on 29th April 2003
which made elaborate provisions on risk mitigations in general including credit derivatives.
Most of these changes have been retained in the final draft.

The essential approach of the Basle II on credit derivatives is substitution approach - that is,
the risk weight of the protection seller substitutes the risk weight of the underlying asset.
The new guidelines put in extensive eligibility conditions for the protection seller, have
dropped restructuring to be a credit event in certain circumstances, have allowed asset
mismatches in certain circumstances, etc.

By way of a general qualification, a credit derivative must be a direct claim on the protection
seller and must be unconditional and irrevocable. The following are the further specific
requirements in case of credit derivatives:
• The credit events specified must at least include the following:
• Failure to pay and analogous events with a grace period that is
consistent with the grace period allowed as for the underlying credit
• bankruptcy, insolvecy or inability to pay the amount, or admission in
writing of its inability to pay, and analogous events
• adverse restructuring of the terms, that is, forgiveness or
postponement of principal, interest or fees that results in a credit loss event
(i.e. charge-off, specific provision or other similar debit to the profit and loss
account).
• In cases where restructuring is not included as a credit event, the
amount of hedge is limited to 60%. In other words, 40% of the
underlying exposure will be deemed as if it is unprotected.
• Asset mismatches, that is, the reference obligation and the underlying asset being
different, are allowed only if it is of the same obligor, and the underlying obligation
ranks at par, or is senior to the reference obligation.
• The credit derivative must not expire before the grace period to be given in an event
of default.
• In case of cash settlements, there must be robust valuation process in place.

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 • The determination of a credit event having happened must be defintive and objective;
in particular, the protection seller must not have the right to notify such event.

Asset mismatches
Asset mismatches, that is, the referece obligation in the credit derivative being diferent from
hedged asset, the hedged asset and the reference obligation must be with the same obligor,
and the reference obligation must be either ranking at par or junior to the hedged obligation.

Eligible protection sellers

The list of eligible protection providers is greatly expanded to include:
• sovereign entities, PSEs, banks and securities firms with a lower risk weight than the
counterparty;
• other entities rated A- or better. This would include credit protection provided by
parent, subsidiary and affiliate companies when they have a lower risk weight than
the obligor.

Capital charge
The capital charge is computed as usual by assigning the risk weight of the protection seller to
the obligor.

Materiality thresholds are equivalent to the first loss, and are a deduction from capital
straightaway.

The w factor contained in the initial drafts is not found in the April 2003 draft.

In case of tranched cover, that is, first loss, second loss or subsequent loss tranched out to
different parties, the rules relating to securitisation framework will be applicable.

This is the original write up before the CP3 issued in April 2003

Update
As per a Sept 2001 update from BIS, the Committee seems to have decided to remove the w
factor charge and replace it with a supervisory charge.
.
BIS II refers to the revised standard on regulatory capital proposed by the Bank for
International Settlements (BIS) in January 2001.

BIS-II lays down new criteria for credit derivatives to provide capital relief to the protection
buyer and capital charge to the protection seller.

Para 117 to 145 of BIS -II provide for impact of guarantees and credit derivatives on bank
capital.
As a general rule, no credit-protected exposure can lead to a higher capital requirement than
identical asset which is unprotected. In other words, protection cannot be worse than the lack
of it.

Basic qualifying conditions

In order to qualify as a credit protection under the norms, the credit derivative must satisfy 4
basic conditions:
• Direct claim on the protection seller
• Explicit and related to specific exposure, not an indefinite referenced asset
• Irrevocable
• Unconditional

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The w factor
The notion of the W factor is based on the assumption that even with protection provided by
the protection seller, there are still some risks on the obligor that are left unprotected.
The w factor in case of credit derivatives is assumed to be 15%.

Computation of risk weightage

The risk weight for a protected transaction is computed based on the weighted average of the
risks of the obligor and the protection seller. In case of a fully protected exposure, the risk
weightage is computed as follows:

r* = w x r + (1 - w) x g

where r* is the adjusted risk weightage to be computed;

w is the factor mentioned above
r is the risk weightage of the obligor
and g is the risk weightage of the protection seller.

So, assuming the risk weightage of the protection seller is 20% and that of the obligor is
100%, the risk weightage of the protected transaction is:

= 15% x 100% + 85% x 20% = 32%

In case the protection is available for a part of the amount of an exposure, the part protected is
subject to the above formula and the balance is treated as unprotected.

In case of tranched protection

Quite common in credit derivatives and credit linked notes is to provide a tranched risk
protection: first loss, second loss and subsequent losses being protected by different parties.

If a bank transfers junior risk and retains senior risk, the extent of junior risk transferred is
taken as protected and the senior risk is taken as unprotected, risk-weighted at the weightage
applicable to the obligor.

For the protection proviver, assumption of junior or first-loss risk leads to a reduction from
capital.

If the transferring bank retains junior risk and transfers senior risk, the junior risk is deducted
from the capital of the protection seller. For the protection buyer, the risk weightage will be
based on the weighted average of the risks of the protection buyer and the obligor, based on a
w factor of 15%.
Operational requirements
There is a set of detailed operational requirements for credit derivatives, listed in Para 126-
128 of the Standard. Notably, the BIS requires that credit event should be defined to include
at least the following:
• failure to pay the amounts due according to the reference asset specified in the
contract;
• a reduction in the rate or amount of interest payable or the amount of scheduled
interest accruals;
• a reduction in the amount of principal or premium payable at maturity or at scheduled
redemption dates;
• a change in the ranking in the priority of payment of any obligation, causing the
subordination of such obligation.

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These definitions are not exactly the same as the ISDA definitions.

As per BIS, only credit default swaps and total rate of return swaps qualify for protection

Equity default swaps use the credit default swap technology, but not to transfer credit risk -
they transfer the risk of major diminution in the market value of shares. Like in case of credit
default swaps, equity default swaps have also been linked to notes and taken into the capital
market in form of "credit linked notes" - you may also call them equity linked notes.

Another interesting dimension in the equity default swap (EDS) application has been that
CDOs have included equity default swaps in their overall portfolio - along with credit default
swaps, total rate of return swaps, etc.

The usual modality of an EDS is to choose a trigger event, similar to credit events - typically
a decline of 30% or more in the equity price of the reference entity from the effective date.
The terms of settlement may be either physical delivery or cash settlement. And cash
settlement might have a binary payout or the actual difference in valuation. In case of binary
settlement, the payout can be based on an assumed recovery of 50%. Thus, if the market value
falls by 30% or more, the protection buyer is paid to the extent of 50% by the protection
seller. Note that neither the decline of 30% is sacrosanct, nor the recovery rate - for instance,
the Zest CDO noted below uses a 70% decline as the trigger point.

While the determination of credit events in credit derivatives is less transparent, the trigger
event in EDS is market information-based, and hence, is more transparent.
EDS and CDS
How do equity default swaps relate to credit derivatives? Credit derivatives are contracts
relating to the general credit of the reference entity. The typical reference obligation is
unsecured loans or bonds - which are technically triggered only after the equity is fully lost.
On the contrary, EDS are latched to a certain percentage loss in equity value - therefore, the
trigger events in EDS will occur much sooner than the credit event in CDS. However, both
relate to the general credit of a reference entity.
EDS and equity puts:
How are EDS different from equity puts? In essence, even a credit default swap is a put, so is
an equity default put. The only distinction possibly is the steepness of the decline in equity
prices and the recovered amount.
Where does it come from?
Quite obviously, the trend towards exotic credit derivative products stems from the urge of
portfolio managers to pick up yields and to introduce more product diversification.
Interestingly, rating agencies have rated CDOs which included equity default swaps. .
EDS activity:
The first notable transaction of CDO incorporating EDS was Moody's-rated Odysseus deal
arranged by JP Morgan, which consisted of a portfolio of 100 reference entities, with 10% of
these being EDS.

In Japan, in February 2004, Daiwa Securities SMBC took the EDS concept a step further
when it launched the first publicly rated arbitrage CDO 100% collateralised by EDS. Zest
Investments V issued ¥31.5 billion of notes in five different classes, backed by EDS on a
portfolio of 30 quoted blue-chip corporates with an aggregate notional amount of ¥45 billion.
Payment to the protection buyer will be triggered if the share price of any of the companies
referenced in the EDS portfolio falls by more than 70% from its initial price and if the share
price fails to recover to the initial level by December 2008.

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Credit Derivatives Move Beyond Plain Vanilla
by Sunil K. Aggrawal
[Sunil Aggrawal's article was originally published on
http://edgar.stern.nyu.edu/~sjournal/articles_00/credit_derivatives.htm We thank Sunil
to have permitted me to reproduce his article on this site. Graphics in the original article
not reproduced here. Sunil Aggrawal can be reached at saggarwal@roosevelt-cross.com]

1. Credit Derivatives
1.1 What are Credit Derivatives?
Credit derivatives are privately negotiated bilateral contracts that allow users to manage their
exposure to credit risk. For example, a bank concerned that one of its customers may not be
able to repay a loan can protect itself against loss by transferring the credit risk to another
party while keeping the loan on its books. This mechanism can be used for any debt
instrument or a basket of instruments for which an objective default price can be determined.
In this process, buyers and sellers of the credit risk can achieve various objectives, including
reduction of risk concentrations in their portfolios, and access to a portfolio without actually
making the loans. Credit derivatives offer a flexible way of managing credit risk and provide
opportunities to enhance yields by purchasing credit synthetically. Credit derivatives cannot
eliminate all credit risk because inherent in the transfer of a loan exposure to Company A, is
the introduction of a new exposure to Company B because of the use of a derivative with
Company B. Generally, AAA-rated Special Purpose Corporations or Vehicles (SPCs or
SPVs) are created to enter into such transactions to reduce the new exposure.

1.2 What is Credit Risk?

Credit risk is the possibility that a borrower will fail to service or repay a debt on time. The
degree of risk is reflected in the borrower's credit rating, which defines the premium over the
riskless borrowing rate it pays for funds and ultimately the market price of its debt. Credit risk
has two variables: market risk and firm-specific risk. Credit derivatives allow users to isolate,
price and trade firm-specific credit risk by unbundling a debt instrument or a basket of
instruments into its component parts and transferring each risk to those best suited or most
interested in managing it. There are various traditional mechanisms to reduce credit risk
including refusal to make a loan, insurance products, guarantees and letters of credit, but these
mechanisms are less effective during periods of economic downturn when risks that normally
offset each other simultaneously default and financial institutions suffer substantial loan
losses.

1.3 Estimated Market and Active Players

Credit derivatives have emerged as a major risk management tool in recent years. The total
volume outstanding of credit derivatives is estimated to exceed $75 billion. Once largely
confined to banks, the market participants have expanded to include insurance companies,
hedge funds, mutual funds, pension funds, corporate treasuries and other investors looking for
yield enhancement or credit risk transference. The market has evolved from the financial
institutions' needs to manage their illiquid credit concentrations and their use of default puts
to hedge their credit exposure. Existing derivative techniques have been used for emerging
market debt and have further been applied to corporate bonds and syndicated bank loans.
Total Return Swaps, for example, were developed to sell customized exposures to investors
looking for a pick-up in yields on their portfolios. These structures enable investors to obtain
exposure to portfolios which were not available to them previously and provides them with
new diversification opportunities.

Several factors have contributed to the development of the credit derivative market. Investors
have shown interest in these products for yield enhancement given the increasingly narrow
credit margins on conventional corporate and emerging market sovereign issues. As investors

11
have come to understand these products more fully, trading volumes have increased. Now
dealers are more frequently warehousing trades in the same way they warehouse and manage
interest rate risk. Over-the-counter brokers have entered the market and the International
Swaps and Derivatives Association (ISDA) is responding to the call for standardized
documentation.

Comments from most market participants indicate a consensus expectation of continued

growth and increased liquidity in the future. Credit derivatives will make credit risk pricing
more efficient, much as Collateralized Mortgage Obligations (CMOs) did for mortgage
pricing, and help segregate credit risk from market risk in bond and loan pricing. Institutions
best suited to handle the credit risk component of these debt instruments will be able to buy
only that portion of the risk and warehouse it.

2. Types of Credit Derivatives

The product menu in the credit derivatives market is changing every day, but there are four
major instruments that make up the bulk of the trading volume today: Total Return Swaps,
Credit Default Swaps, Credit Spread Options and Credit Linked Notes. Terminology varies
among market participants, sometimes based on geography. For example, Credit Default
Swaps are sometimes called Credit Swaps so it is difficult to maintain a consistent lexicon
when discussing this developing market. Traders and marketing staff are careful to provide
detailed descriptions of a transaction-specific payoff profile so it is of more value to
understand under what circumstances one will receive a payment, or be required to make one,
than it is to know a list of product names.
Table 1, from the British Bankers' Association, provides estimates of how credit derivative
trading volume breaks down by product type. Of most interest in this chart is their view of the
likely trend in the market which favors the development of products which allow end users to
manage their borrowing spread over the risk-free rate. With a broad menu of products for
corporate treasurers to manage their absolute exposure to the level of interest rates (swaps,
caps, collars), they will next look for ways to stabilize their company's borrowing spreads.

Table 1
Credit Derivatives’ Share of the Market
By Product
1996 Estimated 2000 Predicted
Market Share Market Share
(%) (%)
Credit Swaps 35 34
Credit Spread Products 15 22
Total Return Swaps 17 19
Credit Linked Notes 27 16
Hybrid Products 6 9

Source: British Bankers’ Association

2.1 Total Return Swaps (TRSs)

A Total Return Swap is a derivative instrument that allows an investor to receive the total
economic return of an asset (income plus or minus any change in capital value) without
actually buying the asset. Exhibit 1 is a diagram of TRS cash flows. One party pays the total
economic return on a notional amount of principal to another party in return for periodic fixed
or floating rate payment (plus some spread). The underlying reference credit (e.g. LIBOR)
can be any financial asset, basket of assets or an index. There can be many variations on the
basic TRS structure. For instance, one can use a basket of assets instead of a single credit.
Maximum and minimum levels for the floating rate leg of the structure can be set via
embedded caps on a reference credit. Maturity of these swaps generally runs from one to
three years.

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Banks use this product as a way of transferring the risk exposure of an asset to another
interested party. Investors seeking exposure to a bank portfolio use TRSs to enhance their
yield. For example, a bank might agree to pay total return on a $50 million loan portfolio to
an insurance company in exchange for semi-annual payments of LIBOR plus 100 basis
points. This allows the bank to reduce its exposure to the credit risk portion of the portfolio
without selling the loans. The insurance company, on the other hand, obtains exposure to the
portfolio without bearing the expense of originating and administering these loans, except via
the bank's margin on the swap. The swap enables banks to keep the entire asset on their
books, but maintain only the desired amount of credit exposure. Why is this of value to the
banks in an era when return on assets is so carefully scrutinized by equity analysts? It seems
on the surface that they would look to move as much off their balance sheet as possible. In
many cases, banks want to keep the loans on their books to avoid jeopardizing their
relationship with a customer or breaching client confidentiality.
Investors can leverage and diversify their portfolios to achieve higher yields by taking on this
credit exposure. A TRS enables the investor to make loans synthetically without the
administrative burden of documenting the loan agreement and periodically resetting the
interest rate. TRSs can provide an extremely economic way of using leverage to maximize
return on capital. The investors do not have to put up $50 million to gain exposure to a $50
million bank portfolio. The exposure on an interest rate is not as large as its notional principal
amount since only the respective interest payments are made. Only the total return of the
portfolio is exchanged with the fixed or floating semiannual payments. Table 2 is an example
of the cash flows of a typical TRS.

Table 2 Total Return Swap Cash Flow Example

An investor desiring exposure to a 10-year BBB corporate bond enters into a 6-month TRS.
Assumptions
Asset: $100MM face value 7.5%, BBB Corporate
Maturity: 6 months
Six-month LIBOR: 5.5%
Financing Spread: 25 basis points
Term of Swap: 6 months
At Inception
All-in Bond Price/Notional Amount 102
At termination Scenario 1 Scenario 2
All-in bond price: 104 3/8 100
Coupon: $3,750,000 $3,750,000
Capital Gain or Loss $2,375,000 ($2,000,000)
Investor Receives: $6,125,000 $1,750,000
Interest Period: 182 days 182 days
Floating Payment: $2,906,944 $2,906,944
Net Cash Flow: $3,218,056 ($1,156,944)

2.2 Credit Default Swaps (CDSs) a.k.a. Default Puts

A Credit Default Swap is another mechanism for distributing the default risk of securities and
loans, enabling lenders and investors to improve risk management and better achieve their
financial goals. In this case, one party makes periodic basis points payments and another party
makes payments for the principal if the "credit default" event occurs. The pricing of such a
derivative depends upon the credit quality of the reference credit, supply and demand for the
reference credit, and prevailing credit spreads. The objective might be any of the following: to
sell a specific risk, e.g. country risk in a project finance transaction, to free up credit lines for
a specific customer, to pick up additional yield by assuming the credit risk, to improve
portfolio diversification, to gain exposure to credits without buying the assets or to assume an
off-balance-sheet synthetic position. Exhibit 2 is a CDS cash flow.

13
Banks that want to reduce or eliminate their exposure to a particular loan or basket of loans
can buy a CDS without the borrower's knowledge or consent (which may be required when
the loans are sold outright). Manufacturing companies that depend upon a limited number of
customers for revenue can buy a CDS on their customers' payment obligations. Investors who
need to protect themselves against default but cannot or do not want to sell the at-risk security
for accounting, tax or regulatory reasons, can buy a Credit Default Swap. Investors can pick
up additional yield without buying an asset, holding it on their balance sheet and funding it.
Building on the basic swap structure, investors can swap the default risk of one credit with
that of another credit. This can help companies diversify their portfolios while avoiding the
transaction costs associated with buying and selling many individual securities or loans.

Credit events in such transactions are pre-defined in the agreement, which could include a
payment default, bankruptcy or debt rescheduling. The credit event must be material and
objectively measurable, this has been one of the major issues addressed by the International
Swaps and Derivatives Association (discussed in Section 5). The reference credit can be
almost any loan or security, a basket of loans or securities, regardless of the currency, and the
tenure of the swap can match or be shorter than the tenure of the reference credit.

2.3 Credit Spread Options

Buying or selling an option on a borrower's credit spread provides an opportunity to gain
exposure on the borrower's future credit risk. One can lock in the current spread or earn
premium for the risk of adverse movement of credit spreads. It also presents a method of
buying securities on a forward basis at favorable prices. Credit Spread Options are normally
associated with bonds, which are priced and traded at a spread over a benchmark instrument
of comparable maturity. The yield spread represents the risk premium the market demands for
holding the issuer's bonds relative to holding riskless assets like U.S. Treasuries. Options can
refer to the borrower's spread over U.S. Treasury Bonds, LIBOR or any other relevant
benchmark.

For example, an investor might sell an option on the credit spread of a BBB-rated corporate
bond with 5-year maturity to a bank in exchange for a premium up front. The option gives the
bank the right to sell the bond to the investor at a certain strike price (assume 150 basis
points). The strike price here is expressed in terms of credit spread over the 5-year Treasury
note. On the option's exercise date, if the actual spread of the corporate bond is less than 150
basis points, the option expires worthless. If it is higher than 150 basis points, then the
investor delivers the underlying bond and the investor pays the price whose yield spread over
the benchmark equals 150 basis points.
This structure allows investors to buy the bonds at attractive terms. If the option expires
worthless, the total cost of bond is reduced by the amount of the premium. Otherwise the
investor pays for the bond at the chosen strike price. There could be different strategic
variations of this, such as (i) using options on credit spreads to take position on the relative
performance of two different bonds and (ii) locking in the current spread by buying calls and
selling puts on the spread with the possibility of earning a premium in the transaction. Again,
this derivative structure allows investors to take a position in the underlying assets
synthetically rather than buying assets in the cash market.

Credit spread options also give end users protection in the event of a large, unfavorable credit
shift, which falls short of default. Spreads should move to reflect any downgrading in the
credit rating. End users who purchased spread options will be able to cash in even though the
referenced credit has not defaulted.

2.4 Credit-Linked Notes (CLNs)

The Credit-Linked Note market is one of the fastest growing areas in the credit derivatives
sector. Under this structure, the coupon or price of the note is linked to the performance of a

14
reference asset. It offers borrowers a hedge against credit risk and investors a higher yield for
buying a credit exposure synthetically rather than buying it in the publicly traded debt.

CLNs are created through a Special Purpose Company (SPC), or trust, which is collateralized
with AAA-rated securities. Investors buy the securities from the trust that pays a fixed or
floating coupon during the life of the note. At maturity, the investors receive par unless the
referenced credit defaults or declares bankruptcy, in which case they receive an amount equal
to the recovery rate. Here the investor is, in fact, selling the credit protection in exchange for
higher yield on the note.

The trust on the one hand enters into a default swap with a deal arranger. In the case of
default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee.
This annual fee is passed on to the investors in the form of a higher yield on the notes. In this
structure, the investors can obtain higher yield for taking the same risk as the holder of the
underlying reference credit. The investor does, however, take the additional risk, albeit
limited, of its exposure to the AAA-rated trust. The Credit-Linked Note allows a bank to lay
off its credit exposure to a range of credits to other parties. J.P. Morgan has completed one of
the more noted CLN transactions, which was based on the credit of Wal-Mart.

2.5 Other Credit Derivatives

2.5.1 Asset Linked Trust Securities (ALTS)
These are Special Purpose Vehicles (SPVs) created by Barclay’s Zoete Weld that allow
investors to combine securities, loans and other financial assets with a swap or other
derivative products to produce customized cash flows. They transform one or more attributes
of the underlying asset, or basket of assets, and enable investors to benefit from derivative
technology without directly entering into a derivative transaction.

In a typical transaction, each investor purchases an Asset Linked Trust Security (ALTS)
certificate, which represents an interest in a separate and independent trust and entitles the
investor to participate in the cash flows from the underlying instruments. ALTS trusts can
accommodate all kinds of financial assets and credit derivatives and provide the same benefits
as the derivative instruments themselves. For example, they allow investors to access the bank
loan market without the operational or administrative burdens of syndicated loan
participation. They provide a cheaper, simpler and more efficient alternative for investors to
diversify their credit exposure through the purchase of a basket of loans or securities and
derivatives.

2.5.2 Chase Secured Loan Trust Notes (CSLT)

Chase Secured Loan Trust notes offer investors access to the high-yield bank loan market.
One of the attractive aspects of this market to investors is that, while offering double-digit
returns in many cases, the senior-secured status of bank loans has given them a very stable,
and favorable, default percentage over the years. This is a market that has been widely
untapped by institutional investors with only 20 - 25 percent of the $250 billion in syndicated
leveraged loans outstanding held by this sector. The Chase structure uses credit derivatives to
offer these investors access to this asset class.

Take, for example, an investor who is prohibited from investing in anything lower than
investment grade securities. In the Chase structure, the underlying credit derivative is a Total
Return Swap between Chase and a trust. Chase pays the trust the total return on a loan
portfolio of $100 million for example, which yields LIBOR plus 250 basis points. In
exchange, Chase receives LIBOR plus 100 basis points from the trust. An investor who
purchases a tranche of the CSLT in the form of a note receives the same return on the loan
portfolio that is received by the trust from Chase on the TRS. For this return, the investor
does not put up the total $100 million as would be required to participate in actual loan
syndication. Rather, the investor pays $20 million for the tranche, which is used by the trust

15
to purchase treasuries to post as collateral against the trust's payment on the TRS. When all
the cash flows are broken down on the transaction, including the five times leverage of the
$20 million for access to the $100 million loan portfolio plus the yield on the treasuries of 6
percent, the investor generates a total yield in this example of 13.5 percent.

3. Credit Derivatives Applied

3.1 Loan Portfolio Management
Credit risks are one of the most significant risk classes for financial institutions. Until
recently, there has not been a developed, liquid market for trading credit risk. Financial
institutions have concentrated on their net market exposure sometimes at the expense of
increasing the credit risk to certain companies. Credit derivatives allow financial institutions
to change their exposure to a range of credit-related risks. As outlined above, there are
different structures which allow the transference of credit risk from one party to another. The
choice of the product depends upon the goals a financial institution is looking to achieve. In
some cases, the bank can buy protection in the form of default puts to transfer the credit risk
to an insurance company or other institutional investors. Additionally, the bank may swap one
credit for another credit of equal rating, just to reduce its exposure to one party.

A loan portfolio manager can achieve any of the following objectives:

• Control credit risks of any debt instrument or basket of instruments by selling or
transferring the credit exposure of the portfolio;
• Reduce a particular risk concentration in the portfolio;
• Create synthetic assets tailored to meet their needs;
• Provide a diverse menu of global exposures to achieve portfolio diversification; or
• Gain exposure to another bank's loan portfolio without participating in the syndicate.

The following example walks through a TRS transaction, starting with the situations of the
parties involved, then proceeding to the credit derivative solution.

Party A is a smaller Texas-based bank with a concentration of loans and revolving credit lines
to a group of independent oil and gas producers, as well as energy service companies, whose
interests are tied heavily to the development of new offshore natural gas field in the Gulf of
Mexico. All companies are privately held with their rights to various parcels of the gas field
as their primary assets. The bank's original intent was to have a portfolio of approximately
$100-$150 million in loans outstanding to undeveloped properties. With several loan officers
approving business out of three different offices, current exposure has reached $300 million.
Efforts to syndicate the loans have been unsuccessful due to the lack of fallback assets if the
properties fail and market perception that the producers should have been sent to the high
yield market. While pricing of the loans is favorable averaging LIBOR plus 300 basis points,
the bank is looking to reduce its exposure to this loan portfolio.

Party B is a mid-size money management company who caught wind of the development of
this new site in the Gulf and is keenly interested in the upside of the property. One of the
fund's managers is a close friend with the developer of the current generation of seismic
imaging that discovered the gas field and thinks it will be a winner. Efforts to gain an equity
stake in any of the small producers with rights to the field were rebuffed, which only served
to solidify the manager's conviction that the property will succeed. The fund manager wants
exposure to these fields because he thinks the high rate of return the market is pricing into
these credits is unjustified. He is looking to tap into the bank's loan portfolio but is prohibited
from taking actual loans into the fund portfolio via syndication. He is also looking to leverage
up his exposure to the field if possible.

Using a TRS passed through an AAA-rated trust, Party A agrees to pay party B the total
return on $100 million dollars worth of the reference loan portfolio. This return will be a

16
function of interest earned on previously distributed loans, future drawdowns of revolving
credit agreements and default losses. Party B agrees to pay Party A six month LIBOR plus
150 basis points. Exhibit 3 illustrates these cash flows.

In this example, a Chase Secured Loan Trust note could be used to allow the investor to
leverage up his position in the loan portfolio, or he could place the full $100 million with
Party A. The fund manager who is looking for maximum returns will likely opt for the
leveraged position in this instance. The pricing is fairly simple since the spread on the loan
portfolio has been established already, the dealer must only factor in the cost of administering
the portfolio and his desired return on the swap to arrive at rate on the TRS.
Hedging is not a real issue in this case because the swap from the bank's perspective is
reducing credit risk on the loan portfolio and adding credit risk to the fund company. As such,
the trade is a form of risk diversification. For the fund manager the situation is much the
same: he is gaining access to a credit exposure that he wants and will likely not hedge the
position. If hedging were desired on his part, his alternatives would be limited since there are
no publicly traded securities of any of the companies in the loan portfolio. This would remove
any replication strategies that are commonly used by dealers running hedged books in these
markets.

Once the trade is booked, what are some of the system implications for Party A who has now
swapped out of some of their loan portfolio risk and added a TRS to its books? If a separate
desk manages the derivatives, which is likely, the cash flows and the default percentages on
the $100 million worth of loan portfolio must now be monitored. Together, the cash flows
and default percentages will determine the payouts to the trust and to the fund. This creates
the need for a system to track loans. What if the desk has other credit derivatives that it has
hedged with short or long corporate bond positions or equity positions? The particulars of any
credit derivative could have the credit derivatives desk relying on daily mark-to-market
calculations from various groups in the bank. This can create control problems and make it
difficult for the desk to mark their positions in a timely fashion. Reliance on disparate systems
with different reporting methods is not ideal and is one of the challenges faced by innovators
in this field.

3.2 Merger and Acquisitions Transactions

Credit derivatives are currently actively used for leveraged mergers and acquisitions (M&A)
transactions. Lenders who finance such transactions can use credit protection to manage
exposure to the acquirer of a target company. The funding exposure can be in terms of bridge
financing or a permanent syndicated loan used to finance the transaction.

For example, Company A, the acquirer of the target Company B, intends to finance this
acquisition through a syndicated loan of $5 billion. Before a permanent financing could be
arranged, Bank C may provide bridge financing for the transaction and possess the credit
exposure to Company A. Bank C can enter into a default swap with a Dealer D, or a
combination of dealers, to protect itself against the credit of A. Since the transaction size is
enormous, no one dealer will buy the whole credit exposure and a combination of dealers is
needed.

Another arena where credit derivatives can be used in an M&A transaction is the merger of a
stronger credit with a weaker one that will potentially downgrade the credit of the combined
firm. A lender that is exposed to stronger credit can buy credit protection or buy a put option
on the credit spread of Company A to protect itself from any downgrading of the referenced
credit.
Another application of credit derivatives in an M&A transaction is to free credit constraints.
For example, Bank C may not be able to provide bridge or permanent financing to the
acquirer company A since it has reached the maximum credit limit with A. To free this
lending constraint, it can transfer the risk of the existing credit lines by entering into a default

17
swap with other credit dealers. By doing so, it will expand the bank's capacity to assume
additional lending and provide the needed M&A financing to Company A.

To hedge the risk of a credit derivative in a large M&A transaction, one can diversify the
credit risk by entering into syndication or repackaging the credit risk and sell it off in the
credit markets. The pricing of these products is generally done using the benchmarks in the
cash markets. If such cash market benchmarks are not available for any particular market,
then default probability and recovery rate models are used to price credit derivatives. As per
one dealer, option-pricing models have been used to price credit options.

4. Pricing & Hedging Considerations

4.1 Pricing Issues
Credit derivatives sit at the intersection of traditional insurance or guarantee products and the
financial derivatives. Each of these areas has their own valuation methodology. Neither of
these methodologies is entirely satisfactory for the valuation of credit derivatives. The
insurance industry typically uses historical data to value insurance policies relying on
actuarial science and the probability of payment-triggering events.

Credit rating agencies have tables of probability of downgrading or default by maturity,

which some derivatives practitioners use. These tables, however, are based on strong
assumptions: (i) they assume that the future will be like the past, (ii) they do not take into
account market information available in the form of credit spreads and (iii) they assume that
exposure to different entities is unrelated. On the other hand, derivative dealers use market-
based information to price their products. The derivatives community uses this information
based on the assumptions of risk neutral valuation and arbitrage-free complete markets. Credit
markets are not liquid enough to be perfect, nor is there a complete set of financial
instruments available for precise valuation.

There is also the question of which stochastic process to assume for different credit events.
Do all credit events follow the same processes or are unique processes for each industry or
each state of the economy needed? While these are some daunting problems to solve, very
little business would get done if the market waited for precise answers. Wall Street’s
derivative houses are constantly at work to improve valuation methods, and seek arbitrage
opportunities due to mispricing, but there are necessarily some assumptions used in the
pricing of credit derivatives. The following is a brief list of some techniques in use today.

Ratings-Based Default Probability Models

These pricing models rely on credit ratings and published data on default losses, such as the
Altman Dataset, to approximate the probability of default of a given issuer. This data is then
supplemented by the dealer's assumption about what the likely recovery rate will be in the
event of a default, i.e. how far below par will the debt be trading when the company
announces its default. Some models for determining the recovery rates in default use fixed
percentages based on industry or credit ratings, while others rely on random, stochastic
processes for default. These pricing models are good in that they are not overly data intensive
and rely more on aggregate statistics. With regards to a new issuer, this model is good in that
it does not require issuer-specific data sets. It does however limit one’s ability to introduce
specifics about a particular issuer.

Credit-Spread Based Default Probability Models

These models track an issuer's credit spread over time and for differing maturities to establish
a term-structure for their credit risk. Once this term structure is established, it is then used to
estimate the probability of default of the issuer for a specific term. One of the advantages of
this approach is that it allows for the use of issuer-specific data. Some weaknesses of this
approach include the fact that a complete term structure of credit spreads for most issuers is
not available, i.e. a company might have only three tranches of public debt of maturities of 2,

18
7 and 30 years. To use this data one must interpolate between these small number of points.
Another assumption included in this model is that the entire spread over riskless assets is due
to credit and does not consider market risk.

Pricing Based on Guaranteed Product Markets

Pricing based on guaranteed product markets is perhaps the simplest approach but is very
limited in that it requires comparison to a credit default instrument already priced in the
market. For example, if two counterparties have an agreement whereby one party is paying
the other a margin of 100 basis points to guarantee the debt of a third party, then any similar
default products on the third party should be priced similarly.

Replication/Cost-of-Funds Models
This model uses the hedging costs of a credit derivative as the basis for its pricing. Basically,
the dealer decides – using probability models, default ratings or whatever he likes – what
portfolio of assets he requires to hedge the payments under. In the example above, the dealer
used a Total Return Swap. He next decides what kind of margin he requires on the TRS. The
combination of the cost of constructing a hedge, along with the dealer's required return,
establishes a price for the credit derivative. This is perhaps the most straightforward approach
for cases when a hedge can be constructed and hedging or replication-pricing methods are
common in all derivative areas. Problems arise, however, when a good hedge is not available
or the costs associated with putting it together are too expensive.

4.2 Hedging Issues

The majority of credit derivatives outlined in this paper have themselves been the hedge to an
existing exposure of the dealer, i.e. the TRS issued on a bank's existing loan portfolio serves
as a reduction of the bank's risk and does not require hedging. What about stand alone trades
where the dealer has no exposure to a particular area but is asked by a client to provide
default protection against someone's receivables?

The main avenue available to credit derivatives dealers in these cases involve constructing
replicating portfolios as best they can, using either the company's publicly traded bonds,
equity or by opting for positions in a comparable company in the same industry. The
techniques employed are comparable to the delta hedging of an options portfolio and require
the dealer to make assumptions about the volatility (i.e. the probability of default) of the
company being guaranteed. The dealer builds an offsetting portfolio whose positive return
will mimic the loss incurred on the default protection in the event of default. Typical hedges
involve shorting the companies bonds or equity. The particulars of an industry might allow a
dealer to use a less-conventional hedge. For example, if the dealer suspects that the default of
Lockheed on its bonds is a function of whether they win an upcoming contract on which they
are bidding against Boeing and Airbus, the dealer might establish a small long position in
Boeing stock as an additional hedge.
The hedging of credit derivatives, or any financial derivatives for that matter, is not an exact
science. If the question, "How would you hedge the following default swap?" was posed to
five credit derivative dealers, one would likely receive five slightly different answers.

5. Documentation and Regulatory Issues

5.1 Documentation
Due to the recent development of this market, there is a lack of standardized documentation
and terminology for most credit derivatives. How to define a "credit event" can be cause for
much debate when documenting a trade. In some cases, it has been defined as widening of the
spread of the referenced credit from a benchmark by a certain number of points (i.e., 150
basis points over LIBOR) but other definitions are possible. How does one define the
recovery value of an asset? Again various methods have been developed most of which
include the conducting of a poll of the dealer prices for a predetermined period (e.g. two to
three times per month for three months) until the value gravitates toward some mean price.

19
The focal point for all derivatives documentation is the International Swaps and Derivatives
Association (ISDA) which is an industry trade group that collaborated on the first interest rate
swap master agreement and has developed most of the standard documentation in the
derivatives industry. ISDA has a task force that is developing standard documents for credit
derivatives. In discussions with Chris Fowler of Chase Manhattan's Credit Derivatives desk,
he stated that ISDA has recently completed a standard document for Total Return Swaps,
which is being circulated for comments. They are also compiling a list of definitions and,
among the completed set, is a standard definition of "credit event."

Based on the success ISDA has had in the interest rate, foreign exchange and commodity
markets in establishing its documents as the basis for market growth, it seems likely that the
credit derivatives market will benefit from the same type of documentation.

5.2 Regulatory Issues

The main regulatory hurdle, which is affecting the growth of the credit derivatives market,
concerns the allocation of capital on a financial institution's balance sheet against outstanding
credit derivatives contracts. Regulators set rules which define the amount of capital a firm
must hold against its various risk positions. The amount of capital necessary for a given
position is usually dependent on its relative risk. The firm needs more capital if the position is
highly risky and less for higher quality assets. The Capital Adequacy Directive (CAD) of the
European Union has defined various risk categories. Capital charges are made according to
the risk categories of the position, including market risk, counterparty risk, large single party
exposure and foreign exchange risk. A firm must have more capital than the sum of these and
other charges due against all of its positions.

Credit derivatives pose problems both in terms of risk categorization as well as in netting of
credit derivatives exposures against underlying loan portfolio exposures. They offer in many
instances the possibility of offsetting counterparty risk against the market risk but may not
achieve a reduction in risk capital requirements from the regulators. For example, a TRS may
allow a credit exposure to be transformed into a market exposure plus some other
counterparty exposure. The bank entering into the TRS against its existing loan position will
be required under existing regulation to hold capital against both the loan and the offsetting
credit swap, thus excluding any net benefit.

Various issues need to be sorted out, among them: Do default puts attract position risk
charges? If yes, what are the appropriate risk weightings? What offsetting, if any, should be
allowed for credit derivatives? What percentage of notional amounts must be held against
different credit derivative transactions?

As was discussed above, there is still a lack of uniformity in the documentation of credit
derivatives and the legal basis of many contracts remains unsupported by opinions. Given this
situation, regulatory authorities are issuing capital treatment charges on an instrument by
instrument basis. Given that capital charge treatments already exist for spread options and
asset swaps, how the rules can be extended consistently to explicit credit derivatives is one of
the questions facing the industry. Another question is when, if at all, regulators will recognize
firms' internal models for credit derivative valuation. This problem is aggravated by the
absence of widely accepted valuation techniques for credit derivatives.

Major market regulators including the Bank of England, The Bank for International
Settlements and the Federal Reserve all have the credit derivatives market on their radar
screens and will be issuing more specific guidelines as the market develops. For the moment,
however, market participants are left with only a consultative paper from the Bank of England
and Federal Reserve banking book guidelines for direction on capital allocation.

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There have been no formal statements made about the netting of capital requirements for
portions of loan portfolios, which have been swapped out through derivatives. Perhaps the
best summary of the state of regulatory affairs in the credit derivatives market is that it
remains a work in progress. The only thing that is certain at this point is that Wall Street
financial innovators wait patiently for new product ideas to come out of any changes in the
regulatory framework.

6. Conclusion
Credit derivatives have many uses and provide flexibility to transfer and price credit risk
more efficiently. The market has been estimated to cross $100 billion, but is growing
throughout the world. The expected defaults in the Asian markets are expected to add to this
growing market. Credit derivatives are likely to be used more extensively in those situations
where buying or selling in cash markets is cumbersome and less efficient.

References
Articles
BZW, "An Investors’ Guide to Credit Derivatives," Derivatives Strategy (Credit Derivatives
Supplement)(June 1997).
Irving, Richard, "Credit Notes in Recent Deals," Risk (September 1996).
Masters, Blythe, "A Credit Derivatives Primer," Derivatives Strategy (May 1996).
Murphy, David, "Keeping Credit Under Control," Risk (September 1996).
McDermott, Robert, "The Long-Awaited Arrival of Credit Derivatives," Derivatives Strategy
(December 1996/January 1997).
Paul-Choudhury, Sumit, "Safe and Secure?" Risk (August 1996).
Nicholls, Mark, "Banking on a Compromise," Risk (Credit Risk Supplement) (July 1997).
Smithson, Charles (with Hal Holappa and Shaun Rai), "Class Notes: Credit Derivatives (2),"
Risk (June 1996).
Spinner, Karen, "Building the Credit Derivatives Infrastructure," Derivatives Strategy (Credit
Derivatives Supplement) (June 1997).
Styblo Beder, Tanya and Frank Iacono, "The Good, The Bad - and The Ugly?" Risk (Credit
Risk Supplement) (July 1997).
Whittaker, J. Gregg and Wendy Li, "An Introduction to Credit Derivatives," Risk (Credit Risk
Supplement) (July 1997).
Internet
ISDA web page provided information on the status of the Credit Derivatives Task Force
Interviews
Informal discussions with the following professionals have contributed a great deal to this
project:
Chase Manhattan Credit Derivatives Group
Gregg Whittaker, Vice President - Risk Management
Matt Fahey, Vice President - Risk Management
Chris Fowler, Vice President - Marketing
Joyce Frost, Vice President - Marketing
Bankers Trust
Phil Borg, Vice President, Credit Derivatives Group
Deutsche Morgan Grenfell
Seldon Sussman, Vice President, Credit Derivatives

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