Submitted To : Ms.

Drashti Shah Date : 21st March 2014

Credit Derivatives
Credit risk is the risk of default by counterparty to a loan transaction, and is different from market risk. There are ways of assessing market risk but the same principles of its measurement cannot be applied to measure the credit risk

As borrowers do not pay in excess of what is

owed. Therefore, returns from debt cannot be regarded as having normal distribution.

Returns from Credit

A trading portfolio may pay more than expected if the going is good while a loan portfolio never pays in excess of interest and principal. Therefore returns from debt cannot be regarded as having normal distribution. Debt is not traded as much as equity and is rather illiquid. Significant part of debt remains an over-the-counter product as financial institutions and banks make loans.

Default Events
Credit derivatives are instruments that provide hedge against the credit risk. Actual defaults take place directly are preceded by some events that forewarn default. The events that signify default include

Downgrade of the firm debt issued by them, Bankruptcy Losses Falling economies Movements of interest rates and exchange rates.

Securitization
Loans are non-transferable and lack liquidity. Therefore holder of these loans may convert such non-tradable assets into tradable ones by a process called securitization. Securitization enables marketing of debt as packaged products, to those who chase higher returns, and in the process assume the risk of the credit i.e. risk of default. However, securitization is not essential to credit derivatives.

Definition of Credit Derivatives

We may define a credit derivative as assets whose returns are related to credibility of the firm as assessed by the credit rating agency. The credit risk primarily means that the bond would not pay the promised cash flow. Credit derivatives are instruments intended to cover the credit risk for a fee.

Returns Credit Derivatives

A credit derivative would be an instrument that derives its value from the spread of the yield over the risk free rate, rather than the absolute yield of the instrument. The return on the debt instruments is supposed to cover the risk of default as well as the downgrade. With each downgrade the market value of debt instrument declines.

Features Credit Derivatives

Credit derivative enable passing the credit risk of an asset to third party. Credit derivatives permit an investor to replicate the returns of a financial instrument, or a portfolio of assets, or an entity without directly engaging into the underlying transaction of advancing.

Features (Contd.)
Under credit derivative transaction the loan or the investment in the portfolio of credit risky assets continues to remain with the original investor, while the credit risk stands transferred to another party. Exposure of underlying asset is not essential as is true with derivatives. One can trade a put or call option with or without cash position on the underlying asset.

Credit Risk Probability of Default

Credit risk is difficult to measure. One way of measurement is to find the probability of default. Probability of default is implied in the yields the bonds offer.

if yields on one year risk free bond and a

corporate bond were 6% and 6.50% respectively, then the extra return of 0.50% is associated with the default of the corporate bond over its maturity.

Probability of Default

The value of the bonds would be as under :

Calculation
= 100

Particulars
Value of Risk free bond with 6% YTM

Answer
Rs 94.1675 Rs 93.7067

* e -0.06*1

Value of Risk free bond with 6.50% = YTM

100 * e-0.065*1

Alternatively stated the difference of value of the two bonds of Rs 0.4608 (94.1675 93.7067) is the present value of loss on attributed to default in one year.

Probability of Default (Contd.)

Similarly, for 2-year zero coupon bond if the yield is 6.75% the difference of its value and the government bond is equated to the expected loss due to default.
Calculation Answer Rs 88.6920 Rs 87.3716

Particulars Value of Risk free bond with 6% YTM Value of Risk free bond with 6.75% YTM

= 100 * e -0.06*2
= 100 * e -0.0675*2

The value loss from default over two years is estimated as Rs 1.3204.

Credit Default Swaps (CDS)

Cash Flow - CDS

CDS is an arrangement where a protection buyer pays periodic premium for compensation of potential loss from default. The obligations of protection seller are contingent upon happening of the defined default events. Default events are the events for which the protection seller would compensate the protection buyer.

Default Events

Default events set a prior normally include :

Downgrades

Bankruptcies
Mergers Restructuring of the Reference entity

Upon occurrence of any of the default event the premium stops. Protection seller pays the agreed amount upon happening of default event.

Settlement of CDS
The CDS concludes on scheduled termination date or the happening of the credit event whichever is earlier. If the period of swap ends without credit event happening there is no cash flow. The premium too ceases. Under cash settlement the asset remains with the protection buyer with loss compensated by the protection seller. Under physical settlement asset is delivered to the protection seller for face value.

CDS and Insurance

The payment made by the protection seller in case the default event occurs is called protection payment. This is often similar to as insurance contract. The difference in the insurance contract and the credit default swap is that :

Under insurance the loss must actually be

incurred, and proved and paid only to that extent . Under CDS mere happening of the credit event is sufficient cause for protection payment and the actual suffering of loss is immaterial.

CDS and Financial Guarantee

Credit derivatives allow hedging with third party, without the reference obligation performing any role in the transaction. This enables creditor to transfer the credit risk without letting the debtor know of it. This is a major difference between a credit default swap and a financial guarantee as former is bilateral while the latter is normally trilateral.

Application of CDS

Income Generation for Protection Seller :

Protection buyer is insured against the default the

protection seller has a synthetic position of the reference obligation, say a bond. CDS creates a position on the reference asset or entity without owning it. Protection seller has not funded the asset or loaned and yet receives a return in the form of premium that is determined on the basis of credit performance.

Application of CDS (Contd.)

Risk Free Position for Protection Buyer:

CDS enables take a risk free position for the

protection buyer. If a corporate bonds provides returns of 200 bps over risk free bonds then CDS premium would be 200 bps. Therefore
Post CDS the investor would earn risk free return. Through CDS the investor obviated the need for

changing his portfolio. Also investor gets protection for the desired time.

Application of CDS (Contd.)

Diversification of Risk for Buyer and Seller:

Another interesting application of CDS is that it

helps achieve diversification. Assume two banks specializing in agricultural and automobile sectors.
Bank advancing farm loans faces default risk

emanating primarily from weather conditions. Bank concentrating on auto loans faces default risk that primarily emanates from economic conditions. Both the banks can diversify their risks by entering into two independent credit default swaps

Total Return Swap (TRS)

Under total return swap coupon as well as capital appreciation are passed to the receiver who also assumes credit risk on the asset.

Cash Flow of TRS

On each coupon date: Payer pays coupon, the regular return and receives floating rate plus spread. Capital gains/loss can be paid/received either at each payment date or at the end. On conclusion of swap: Payer pays capital gain on the value of the asset to the receiver. This compensates for the capital gain/loss on the reference asset by finding the difference in the market value at inception and at conclusion.

Cash Flow of TRS (Contd.)

If there is default during swap period: The swap is terminated with the loss on the reference asset due to default compensated by the receiver to the payer.

Returns Under TRS

Total Return Swap & Interest Rate Swap

Under interest rate swap only interest rate risk is covered and default risk is not covered. Under interest rate swap

Fixed rate payment is analogous to coupon

payment under TRS. There is no compensation for the gain/loss in the value of the asset. The default on the reference asset has no implication on the cash flows of the conventional interest rate swap.

Under TRS default risk is covered.

Total Return Swap & Credit Default Swap

Under CDS only default risk is covered and interest rate risk is not. TRS covers both. Total return swap provides :

a superior protection for the payer than what

CDS does for the protection buyer. Compensation for the loss on the value of the reference asset apart from the default risk.

Total return swap:

covers both interest rate risk and default risk. Is a combination of IRS and CDS.

Credit Linked Notes (CLNs)

Credit Link Note (CLN) is a funded product that augments the resources of issuer as well as transfers the credit risk. In CDS, there in no cash flow from protection seller to protection buyer at the inception. CDS is said to be non-funded or unfunded. Unfunded derivative instrument synthesizes the position of an instrument without investment

Credit Linked Notes The Funded CDS

CDS can be converted into a funded product :

Where protection seller may make full or partial

upfront payment to the protection buyer at the inception of the contract. This is usually achieved by issue of note by the protection buyer is bought by the protection seller. Such an instrument is called a Credit Linked Note.

CLN becomes a funding instrument such as bond that provides protection against default or credit event such as credit default swap.

CLN A Deeper Look

Credit Link Note may be defined as a :

hybrid instrument that offers investors a synthetic

credit exposure to a specified reference entity or a basket. A CLN may provide for its principal repayment to be reduced below par in the event a reference obligation defaults. CLN is therefore a structured product where coupon/interest payment and principal are linked to performance of a reference obligation.

CLN A Deeper Look (Contd.)

CLN is on-balance sheet while CDS is off-balance

sheet. CLN as a composite instrument would help achieve the twin objectives of funding and hedging.

Collateralized Debt Obligations (CDOs)

Collateralized Debt Obligations (CDOs) were first introduced in 1988. They are essentially structured finance product that package risk in different classes called tranches. Each tranche is sold to investors interested in yield enhancement and assuming commensurate risk. Each tranche has a different risk return profile dependent upon the credit performance of the underlying pool of asset.

CDOs (Contd.)

The underlying pool of asset can be portfolio of bonds or portfolio of loans. The former is called collateralized bond obligation (CBOs) and latter is collateralized loan obligation (CLOs). Collaterized debt obligations categories credit risk and investors choose the risk return profile.

Typical CDO

CDOs
The payments under CDO are hierarchical satisfying the claims of investors depending upon their seniority. Interest gets precedence over principal for the note of the same rating, and principal of senior notes gets precedence over the interest of lower rated notes. Coverage tests are conducted at every stage to ascertain adequacy of cash flows.

Cash Flow Priority Under CDO