CREDIT DERIVATIVES

PREPARED BY

GURUPRASAD POOJARI 47
DIWAKAR SUVARNA 18
PRADEEP PRADHAN 45
TRISHUL SHETTY 46
JITESH MALI 62
ROOPA VENKAT 25
VISHAL THAKKER 56

PROF. ANIL SUVARNA

 
BATCH NO - 54
“Credit derivatives are derivative
instruments that seek to trade in credit
risks. ”

“Credit derivatives are bilateral contracts

between a buyer and seller under which the
seller sells protection against the credit
risk of the reference entity.”
The risk that a counterparty to a financial
transaction will fail to fulfill their
obligation.
International Swap and Derivative
Association reported in april 2007 that
total notional amount on outstanding credit
derivatives was $35.1 trillion

"Worldwide credit derivatives market is

valued at $62 trillion".
1. Un funded Credit derivatives
 Credit Default Swap
 Credit Spread Options
 Total Rate of Return (TROR) Swap
 First To Default (FTD) Swap

1. Funded Credit Derivatives

 Credit Linked Notes
Credit default swaps allow one party to "buy"
protection from another party for losses that
might be incurred as a result of default by a
specified reference credit (or credits).

The "buyer" of protection pays a premium for the

protection, and the "seller" of protection
agrees to make a payment to compensate the buyer
for losses incurred upon the occurrence of any
one of several specified "credit events."
Suppose Bank A buys a bond which issued by a
Steel Company. To hedge the default of Steel
Company:

Bank A buys a credit default swap from

Insurance Company C.

Bank A pays a fixed periodic payments to C,

in exchange for default protection.
 Credit Risk

Premium Fee Insurance Company C

Bank A Buyer
Seller
Contingent Payment
On Credit Event

Steel company
Reference Asset
A credit spread option grants the buyer the
right, but not the obligation, to purchase a
bond during a specified future “exercise”
period at the contemporaneous market price
and to receive an amount equal to the price
implied by a “strike spread” stated in the
contract.

Credit spread options are designed to hedge

against or capitalize on changes in credit
spreads
The different between the yield on the
borrower’s debt (loan or bond) and the yield
on the referenced benchmark such as U.S.
Treasury debt of the same maturity.
An investor may purchase from an insurer an
option to sell a bond at a particular spread
above LIBOR Credit spread.

If the spread is higher on the exercise

date, then the option will be exercised.
Otherwise it will lapse.
Profit

Strike price
Spot price
The protection buyer and protection seller swaps
flows, with the risk seller receiving the return on
the asset plus any appreciation and the risk buyer
receiving a regular premium plus any depreciation in
the asset value.

Regular Premium + Depreciation

Protection Compensation if a credit event Protection

Buyer Seller
Coupons + Appreciation of
claim

Coupons

Claim for the

reference
entry
The risk seller agrees to pay a premium to the risk buyer,
while the risk buyer undertakes to compensate the risk
seller for losses on the first underlying asset of the basket
which experiences a credit event

Regular Premium

Protection 0 If no credit event occurs Protection

Buyer Seller
Face value-recovery value if
Credit event occurs

Basket of
Claim
A credit-linked note (CLN) is essentially a
funded CDS, which transfers credit risk from
the note issuer to the investor.

The issuer receives the issue price for

each CLN from the investor and invests this
in low-risk collateral.

If a credit event is declared, the issuer

sells the collateral and keeps the
difference between the face value and market
value of the reference entity’s debt.
Refer to the Steel company case again.

Bank A would extend a $1 million loan to the

Steel Company.

At same time Bank A issues to institutional

investors an equal principal amount of a
credit-linked note, whose value is tied to
the value of the loan.

If a credit event occurs, Bank A’s repayment

obligation on the note will decrease by just
enough to offset its loss on the loan.
 $1 Million

Bank A Institutional
fixed or floating coupon, investors
if defaults or declares
bankruptcy the investors
$1 million

receive an amount equal

to the recovery rate
500b p
Steel
Company

Steel Company
• To transfer credit risk on an entity
without transferring the underlying
instrument
• Regulatory benefit
• Reduction of specific concentrations
portfolio management
• To go short credit risk
 Centrally Cleared Credit Default Swaps (CDS)

 Central Counterparty (CCP) is a Federal Reserve

mandate to allow the Buy Side and Sell Side to clear
swaps derivatives on exchanges. CCP stands between
trade counterparties becoming buyer to every seller,
and seller to every buyer.

 Eliminates bilateral counterparty risk between market

participants

 Manages counterparty defaults through margin

requirements and stringent regulation
 The Fed has established a deadline of December 15, 2009
to get an exchange in place for clearing Credit Default
Swaps (CDS). There are 2 viable contenders :

 CME (Chicago Mercantile Exchange)

 ICE (industry consortium led by the sell-side

dealers)
 Setup for CDS will be like futures

 Up-front fees and termination fees are not

moved and are collateralized separately
(trades booked T+1)

 Margin variation and interest settle daily

on T+1 basis

 Only the change in value from trade date

through EOD gets moved in cash

 Initial Margin is required by the exchange

– Collateral only delivered as initial
margin