Credit Derivatives

Credit Derivatives A credit derivative  financial instrument Allows participants to decouple credit risk from an asset and place it with another party

Credit Risk Credit risk is the risk of loss due to a Debtor's non-payment of a Loan or other line of Credit, either the Principal or Interest (Coupon) or both. To reduce or strip out Credit risk, Risk Manager may : Take Collateral Make loss provisions Actively manage the Credit Risk Exposure or use Credit Derivatives : Credit Default Swaps (CDS)

Credit Risk Downgrade Risk - Rating agency reduces debtor’s credit rating - Reduces value of debt Default Risk - Loan not repaid in full - Future cash flows not certain

Rating Agencies Risk is measured by rating agencies - Moody’s - S&P - Fitch Rating scales:

Types of Credit Derivatives Credit Default Swap (almost 90% of all transactions) Dynamic Credit Default Swap Credit intermediation Swap Basket Credit Default Swap Total Rate of Return Swap Credit (spread) Option Downgrade Option Collateralized Instrument Credit-linked Note Synthetic Collateralized Debt Obligation

Credit Default Swaps CDS 7

First CDS  introduced in 1995 by JP Morgan in an attempt to free up all that capital they were obliged, by federal law, to keep in reserve in case any of their loans went ‘bad’. Estimated Size of the CDS market (Q1 2008): USD 65 trillion Global GDP: USD 55 trillion (2007,IMF)

Characteristics of Credit Default Swaps Market of CDS is divided in three sectors: Corporates Bank credits Emerging markets sovereign OTC agreement (privately negotiated transactions) CDS ranges in maturity from one to ten years Five year maturity is the most frequently traded CDS provides protection only against previously agreed upon credit events

Credit Events According to ISDA 2003 Master Agreement Bankruptcy (insolvency or inability to pay its debts) Failure to pay (principal or interest) Debt Restructuring (change in the terms of the debt that are adverse for creditors) Repayment Acceleration on Default Repudiation (sovereign only – indication that a debt is no longer valid) One of this event has to have happened on the reference entity in order a CDS payment to be made

What is a single CDS Bilateral contract Protection buyer  pays premium to protection seller Protection seller  contingent payment upon default of reference asset One party usually owns the Reference asset Otherwise: transaction does not involve credit exposure  speculation on behalf of both parties Premium paid is known  CDS Spread

Reference Asset Bank loan Corporate debt Trade receivables Emerging market debt Convertible securities Credit exposures from other derivatives

CDS Spread Quoted in Basis Points per annum Paid periodically If corporate quarterly sovereign  monthly Credit Spread =Default probability x (1-recovery rate) Premium = notional amount x CDS spread p.a.

Example on Premium of Bulgarian 5Y CDS Notional amount = USD10,000,000 Spread= 494 b.p. Premium = notional amount x CDS spread = 10,000,000 x 0.0494 = 494,000 p.a.

Payoff from CDS The payoff can be defined in terms of Physical delivery of the reference asset delivery of the Defaulted Bond for the Par value (no later than 30 days after the credit event) or Cash Settlement pays the Protection Buyer the difference between the Par value and (real) Recovery value of the Bond (within 5 days of the credit event) Settlement terms of a CDS are determined when the CDS contract is written

Buyers and sellers of protection

Cash Settlement Example Payoff from a Credit Default Swap Bank A  holds a corporate bond issued by C Reference asset  Bond C, maturing in two years

Cash Settlement Example Payoff from a Credit Default Swap To reduce credit risk: Bank A  enters in two year CDS with Bank B, with notional amount 10 millions (protection buyer) Bank B  contingent payment to A in the event of default of reference asset C (protection seller)

Cash Settlement Example Payoff from a Credit Default Swap Bank A  pays periodically the premium to Bank B CDS on C is quoted 52 bps (per annum) Premium= notional Amount x CDS spread = 10,000,000 x 0.0052 = 52,000

Cash Settlement Example Payoff from a Credit Default Swap After one year: C defaults on the bond by declaring bankruptcy Market value  falls to 48.63% of its par value because Market expectation is that C will only be able to pay back 48.63% of total outstanding

Cash Settlement Example Payoff from a Credit Default Swap The payoff on default will be calculated as follow Notional principal x Par Value – Market Value 100

Cash Settlement Example Payoff from a Credit Default Swap Bank B  makes payment to Bank A USD 10,000,000 x (100–48.63)/100 =USD 5,137,000

Cash Settlement Example Payoff from a Credit Default Swap Net effect CDS  allowed Bank A to insulate itself from credit risk by holding the risky bond C The payoff from sale of reference asset: USD 10,000,000 x 48.63 = 4,863,000

Cash Settlement Example Payoff from a Credit Default Swap Bank A receives the recovery rate from the sale of the underlying reference asset USD 4,863,000 and payoff of USD 5,137,000 from Bank B Total 10,000,000 Bank B acquired the credit risk of holding the bond without actually holding it in return for receiving the premium from BankA

Use of CDS Hedging Protection buyer owns the underlying credit asset Speculation Protection buyer does not have to own the underlying asset

Hedging CDS  manage the credit risk Protection buyer  hedge their exposure by entering into CDS contract IF reference asset defaults  the proceeds from CDS will cancel out the losses on the underlying Protection buyer  will have lost only the payments over that time IF reference asset does not default  protection buyer makes the payments reducing investments returns but eliminates the risk of loss due to reference entity defaults

Speculation Investor  speculates on changes in an entity’s credit quality If credit worthiness declines => CDS spread will increase If credit worthiness increases => CDS spread will decline Example: a hedge fund believes an Entity will default soon  buys protection

Speculation IF reference asset defaults  Protection buyer will have paid the premium but will receive from the protection seller the notional amount making a profit. IF reference asset does not default  CDS contract will run for whole duration without any return

Speculation The hedge fund could liquidate its position after a certain period of time  lock in its gains or losses IF reference asset is more likely to default => CDS Spread widens So, hedge fund  sells protection for the rest of CDS duration at a higher rate => makes profit (given that reference asset does not default during this time) IF reference asset is much less likely to default => CDS spread tightens So, hedge fund  again sells protection for the rest of CDS duration in order to eliminate the loss that would have occurred