Presentation is loading. Please wait.

Presentation is loading. Please wait.

Credit Derivatives - A Buyside Perspective Deutsche Bank Relative Value Summit March 2-6, 2000 Ron D'Vari, Ph.D., CFA Sr. Vice President, Portfolio Manager,

Similar presentations


Presentation on theme: "Credit Derivatives - A Buyside Perspective Deutsche Bank Relative Value Summit March 2-6, 2000 Ron D'Vari, Ph.D., CFA Sr. Vice President, Portfolio Manager,"— Presentation transcript:

1 Credit Derivatives - A Buyside Perspective Deutsche Bank Relative Value Summit March 2-6, 2000 Ron D'Vari, Ph.D., CFA Sr. Vice President, Portfolio Manager, and Director of Quantitative Research State Street Research & Management

2 Credit Derivatives Transactions Most Actively Considered: Asset Swap Total Return and Index Swap Default Swap Other Credit Derivative Structures Under Consideration: Credit Linked Notes (CLNs) Credit Spread Option CBOs, CLOs, Synthetic CLOs Synthetic Leveraged Loan Synthetic Revolving Credit Agreements State Street Research & Management, Ron DVari, Ph.D., CFA2

3 State Street Research & Management, Ron DVari, Ph.D., CFA3 Buyside Credit Derivative Strategies Flexible Credit/Sector Exposure Tailoring –Access: Sourcing names and maturities not available through cash instrument market –Flexibility: Uncoupling of interest and credit exposure Diversification Yield Enhancement –Exposure to short maturities with low price sensitivity Relative Value and Replication –Cheaper synthetic cash positions Hedging Leverage or Financing

4 Buyside Challenges Internal and External EducationInternal and External Education Accurate Portfolio Analytics and Risk ModelsAccurate Portfolio Analytics and Risk Models Consistent Framework for Use In Portfolio ContextConsistent Framework for Use In Portfolio Context Infrastructure: Compliance, Trading, and Accounting SystemsInfrastructure: Compliance, Trading, and Accounting Systems Signing ISDA AgreementsSigning ISDA Agreements –Several hundred plan sponsors and separate accounts –Multiple dealers and banks –A dozen custodians –Legal resources Shortcomings of the Standard Representations in ISDAShortcomings of the Standard Representations in ISDA –Not developed for investment managers acting as agent –Often impossible for managers to make –Requires involvement of plan sponsors and custodians State Street Research & Management, Ron DVari, Ph.D., CFA4

5 Portfolio Level Considerations of Credit Derivatives Besides fundamental analysis of reference credit and counterparty overall portfolio suitability has to be established. Optimal allotment of risk budget to credit derivatives –Portfolios total risk is budgeted to key active exposures Level and shape of term structure of interest rates Volatility Sector/Credit exposures (by sector by credit by maturity) Risk Analysis and Its Transparency –Accurate accounting of credit derivatives in daily and intraday portfolios multi-factor absolute and relative risk reports –Measure credit, spread change, and structural risks Quantitative Relative Value Framework –W.r.t. cash instruments or other forms of risk Liquidity and Pricing Infrastructure State Street Research & Management, Ron DVari, Ph.D., CFA5

6 Infrastructure DocumentationDocumentation TradingTrading Counterparty Risk ManagementCounterparty Risk Management ComplianceCompliance Accounting and CustodialAccounting and Custodial State Street Research & Management, Ron DVari, Ph.D., CFA6

7 Documentation Limited RecourseLimited Recourse –Sub-account managed by manager Size MattersSize Matters –No trigger with account size change –May require lower collateral threshold and minimum transfer CollateralizationCollateralization –Eligibility –Threshold and minimum transfer amount Manager TerminationManager Termination –Avoid early termination through assignment AssignmentAssignment –Both parties consent State Street Research & Management, Ron DVari, Ph.D., CFA7

8 Understanding Factors Impacting Prices Changes in Credit Condition Credit Spreads in Cash Market Cost of Alternatives Regulatory Capital Requirements General Market Liquidity Pricing Models –Traditional Credit Judgment –Quality of Historical Default Rates and Recoveries –Availability and Quality of Historical Spread –Availability of Volatility and Correlation data –Credit Default Swap Curves –Basis Between Credit Swap and Other Credit Pools –Modeling Tranched Credit and Basket State Street Research & Management, Ron DVari, Ph.D., CFA8

9 Buyside Use of Various Credit Derivatives Presentation Focus: Asset Swap Total Return and Index Swap Default Swap State Street Research & Management, Ron DVari, Ph.D., CFA9

10 Asset Swap Motivation Swap floating assets to fixed or vice versa Trade away imbedded options in a bond or layer in options SSRM Counter Party Coupon from Bond A Some Index (Libor, CMT, fixed level etc.) + Spread Bond A Coupon and Principle Market Price State Street Research & Management, Ron DVari, Ph.D., CFA10

11 Index Total Return Swap Motivation Adjust exposure without buying or selling individual securities Hedging, Relative Value, Market access, Flexibility Avoid paying bid-ask spread for a short dated trade Get financing (leverage) SSRM Counter Party Index Sector Total Return Libor + Spread or Total Return of Another Sector SSRM Holdings in a Sector Holdings Total Return Market Price State Street Research & Management, Ron DVari, Ph.D., CFA11

12 Single Reference-Entity Credit Default Swap Transfer the credit risk of an issuer (reference entity) from one entity (buyer) to another (seller) Seller of protection agrees to buy obligations of the reference entity at par in the event of a public notice Default event is defined a publicly available notice to: – –A payment failure larger or equal than Payment Requirement on – –an obligation equal or larger than Default Requirement Settlement can be Physical or Cash Deliverable obligations can be – –Reference obligation – –Any of Deliverable obligations According to ISDA it could be any borrowed money: loans,cp, bond, and bond and loan Must be specified in long confirm State Street Research & Management, Ron DVari, Ph.D., CFA12

13 Advantages of Default Swap over Short Corporates In general they tend to be cheaper than similar cash bond because:In general they tend to be cheaper than similar cash bond because: –buyers inability to hedge their risk in any other market (shorting public debt can be quite risky and subject to adverse technicals) (shorting public debt can be quite risky and subject to adverse technicals) – expensive risk capital charges required against credit risk Increases yield with minimal increase in spread durationIncreases yield with minimal increase in spread duration –Very attractive break-even cushion against spread widening Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection)Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection) More flexibility - Default swap does not tie up cash to earn spreadMore flexibility - Default swap does not tie up cash to earn spread Allows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategiesAllows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategies Access to names and maturities that otherwise may not be availableAccess to names and maturities that otherwise may not be available State Street Research & Management, Ron DVari, Ph.D., CFA13

14 Pricing Methodology State Street Research & Management, Ron DVari, Ph.D., CFA14 Method 1: Basis - Asset Swap vs. Default Swap (works only for single name) Method 2: Model Loss Distribution Market Implied Default Probabilities Credit SpreadsRecovery Rates Asset Correlations Default Correlations Simulator Loss Distribution

15 Pricing Single-entity Default Swap Compare Libor spread of cash bond of the issuer of similar maturity with the default swap rateCompare Libor spread of cash bond of the issuer of similar maturity with the default swap rate Compare all-in yield of a synthetic bond of Default Swap+AAA ABS with the cash bondCompare all-in yield of a synthetic bond of Default Swap+AAA ABS with the cash bond Compare a given spread with valuation based on long-term default probability and recovery rates based on transition probability matrix and recovery valueCompare a given spread with valuation based on long-term default probability and recovery rates based on transition probability matrix and recovery value ACCOUNT Default Option on $10mm TCI 7 ¼ 6/99 COUNTER- PARTY 40BP/Annum AAA Asset Back Maturing 6/15/99 (+20 to 25bp over Treasury) Bond$10mm State Street Research & Management, Ron DVari, Ph.D., CFA15

16 Transition Probability (S&P CreditWeek 15 April 96) Four sources of transition probability matrices: S&P, Moody, CreditMetrix, KMV Over 15 years of data with more than 25,000 firm/years of observations, adjusted for no-longer rated entities State Street Research & Management, Ron DVari, Ph.D., CFA16

17 Recovery rates (CreditMetrix using several studies)Recovery rates (CreditMetrix using several studies) Average Cumulative Default Rates (%)Average Cumulative Default Rates (%) State Street Research & Management, Ron DVari, Ph.D., CFA17

18 Annual Breakeven Spread (1-Spread)^n = (1- Cumulative Default Rate * Recovery Rate) State Street Research & Management, Ron DVari, Ph.D., CFA18 Simple Example of Breakeven Spreads


Download ppt "Credit Derivatives - A Buyside Perspective Deutsche Bank Relative Value Summit March 2-6, 2000 Ron D'Vari, Ph.D., CFA Sr. Vice President, Portfolio Manager,"

Similar presentations


Ads by Google