1. Drake DRAKE UNIVERSITY Fin 288 Credit Derivatives Finance 288 Futures Options and Swaps

2. Drake Drake University Fin 288 Credit Risk Default Risk The risk that the debtor or counterparty will default on its obligation. Migration / Deterioration Risk The risk that there will be decline in the credit quality of the of the debtor or counter party.

3. Drake Drake University Fin 288 Credit Default Swap The buyer makes an upfront payment or a stream of payments to the seller of the swap. The seller agrees to make a stream of payments in the event of default by a third party on a reference obligation.

4. Drake Drake University Fin 288 Basic Credit Default Swap Default Swap Buyer Default Swap Seller Reference Obligation Issuer Upfront Payment or Stream of payments Payment in the Event of Default Return on Reference Obligation Original Payment

5. Drake Drake University Fin 288 Credit Default Swap as an Option The Credit Default Swap is basically a put option on the reference obligation. The default buyer owns the put option which effectively allows the reference obligation to be sold to the CDS seller in event of default.

6. Drake Drake University Fin 288 Intuition Assume that the reference obligation is a bond If the price of a bond decreases due to a change in credit quality, the value of the put option increases. This implies that the value of the CDS increases. The CDS buyer could sell the obligation at a premium compared to what was paid originally.

7. Drake Drake University Fin 288 What Constitutes Default The CDS parties can agree to any or all of the events below Bankruptcy Failure to Pay Obligation Acceleration Obligation Default Repudiation or deferral Restructuring

8. Drake Drake University Fin 288 What Does not Constitute Default Downgrade by rating agency Non Material events (error by employee causing a missed payment etc.)

9. Drake Drake University Fin 288 Hedge against Default In the event of a default the swap buyer is hedged against the risk of default. The CDS is effectively an insurance policy against default. The risk of default is transferred to the seller of the CDS.

10. Drake Drake University Fin 288 Hedge against credit deterioration? Since rating agency changes do not constitute default how are credit changes hedged If the CDS is marketed to market then the change in value serves as a hedge against changes in credit quality

11. Drake Drake University Fin 288 An Example Assume that the CDS buyer owns an 7% coupon bond and the return on a similar maturity treasury is 5%. Assume that both bonds have a current value of $1 Million (equal to their par value) Assume the buyer pays 2% per year for the duration of the swap and receives $1 Million in the even of default. The combination of the CDS and 8% bond have effectively the same payoff as the treasury

12. Drake Drake University Fin 288 Credit Default Swap Default Swap Buyer Default Swap Seller Reference Obligation Issuer 2% per year $1 Million in the Event of Default 7% per year $1 Million

13. Drake Drake University Fin 288 Risks in the CDS The CDS seller may default We assumed that the spread between the two bonds stays constant over time and that the duration and convexity of the bonds stays the same. (unlikely especially for a bond closeto default) We have ignored accrued interest There could be a liquidity premium for the risky bond causing it to sell for less than its true value.

14. Drake Drake University Fin 288 Other CDS variations Binary or Digital Default Swap – Payoff is a single lump sum often based upon recovery rates. Basket CDS - the reference obligation is a basket of obligations N to default – default exists when the Nth obligatin defaults First to default Cancelable DS –either the buyer (call) or seller (put) has the right to cancel the default swap

15. Drake Drake University Fin 288 CDS Variations continued Contingent CDS – triggered if both the default and a second event occur Leveraged CDS – Payoff is a multiple of the loss amount often the standard CDS amount plus a % of the notional value Tranched Portfolio Swaps – A variation of CDOs

16. Drake Drake University Fin 288 Benefits of CDS The risk is transferred to a financial institution that often has better ability to hedge the risk than the swap buyer. Allows lenders to hedge the risk of high risk loans without jeopardizing the lender – client relationship Reduction of regulatory capital.

17. Drake Drake University Fin 288 A costless reduction in risk Assume that Bank A has sold a CDS to Co X on a 100,000,000 notional amount and is receiving a 3% semi annual interest rate Similarly Bank B has the same agreement with Co Y. Assuming both company’s have the same credit quality By exchanging a portion of the notional value of the swap the banks can diversify the credit risk without any costs.

18. Drake Drake University Fin 288 Credit Default Swap Risk Sharing Bank A Company X $50 M of CDS With Co X $50 M of CDS With Co Y Company Y 3% on $100M Bank B Payment If Default Payment If Default 3% on $100M

19. Drake Drake University Fin 288 An arbitrage example Assume that a foreign country is undergoing a financial crisis and bonds based in the country are trading at a high yield of 18% However the CDS premium on the foreign bond is 11% Currently the treasury yield is 5% By shorting the treasury and using the proceeds to buy the foreign bond, the firm can lock in a profit.

20. Drake Drake University Fin 288 Credit Default Swap Arbitrage Arbitrageur Treas Bond Buyer Cash 18% Yield Company Y 11% Premium Foreign bond Seller Payment If Default Treas Yield 5% Cash

21. Drake Drake University Fin 288 Adjusting Regulatory Capital A Banking Example Basel II Accords have specified how risk based capital should be calculated based upon a weighted riskiness of an asset.

22. Drake Drake University Fin 288 New Basel Accord (Basel II) Basel Agreement – imposes risk based capital requirements on banks in major industrialized countries Pillar 1: Credit, market, and operational risks Credit risk: Standardized approach Internal Rating Based (IRB) Market Risk --Unchanged

23. Drake Drake University Fin 288 Basel II continued Operational: Basic Indicator Standardized Advanced Measurement Approaches

24. Drake Drake University Fin 288 Basel II continued Pillar 2 Specifies importance of regulatory review Pillar 3 Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

25. Drake Drake University Fin 288 Capital Divided into Tier I and Tier II Tier I – closely linked to book value, represents the core contributions to banks owners. Includes common stockholders equity, some preferred stock, equity interests of subsidiaries Tier II – secondary capital. Includes loan and lease losses, hybrid capital (perpetual debt), subordinated debt, revaluation reserves

26. Drake Drake University Fin 288 Risk-based Capital Ratios Basle I Agreement Enforced alongside traditional leverage ratio Minimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio. Also requires, Tier I (core) capital ratio = Core capital (Tier I) / Risk-adjusted  4%. Crudely mark to market on- and off-balance sheet positions.

27. Drake Drake University Fin 288 Calculating Risk-based Capital Ratios Tier I includes: book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill. Tier II includes: loan loss reserves (up to maximum of 1.25% of risk- adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

28. Drake Drake University Fin 288 Calculating Risk-based Capital Ratios The risk based capital ratio is based upon the risk weight. The minimum amount to be in capital is 8% multiplied by the risk weight and the notional value of the loan. For example if you made a loan to an A rated corporation it would have a risk weight of 50%. On a $100M loan the required capital would be $100M(.5)(.08) = $4 Million

29. Drake Drake University Fin 288 CDS and risk based capital The original risk weight for the buyer of the credit derivative was defined as r*=wr+(1-w)g where w =.15 for all credit derivatives giving protection r = risk weight of the obligor g = risk weight of the protection seller

30. Drake Drake University Fin 288 An example Assume that you have made a $1,000,000 loan to a corporation with an A rated corporation as before. However now you offset it with a CDS sold by a AAA rated bank with a risk weight of 20%. r* =.15(.50)+(1-.15).20 =.245 This implies a capital requirement of.245(1,000,000)(.08) = $19,600 as opposed to.50(1,000,000)(.08) = $40,000

31. Drake Drake University Fin 288 Weights The 15% weight for the CDS is designed to cover operational risks that might make enforcement of the CDS difficult. The 15% has received much critisisim and a counter proposal would allow the risk weight to be set equal to the credit quality of the seller of the CDS. This could increase, or decrease the new risk weight depending upon the ratings of the original borrower and the CDS seller

32. Drake Drake University Fin 288 CDOs