1. Credit Derivatives Chapter 29

2. Credit Derivatives credit risk in non-Treasury securities  developed derivative securities that provide protection against credit risk types  asset swaps  total return swaps  credit default swaps  credit spread options  credit spread forwards structured credit products  synthetic CDOs  credit-linked notes

3. Credit Derivatives types of credit risk  default risk  credit spread risk  downgrade risk categories of credit derivatives

4. Credit Derivative Terminology reference entity (reference issuer) reference obligation (reference asset) credit event  bankruptcy  credit event upon merger  cross acceleration  cross default  downgrade  failure to pay  repudiation/moratorium  restructuring

5. Asset Swaps example  investor purchases $10m par of 7.85%, 5 year bond of BBB-rated firm at par with semiannual coupons  investor enters into 5 year swap where he is fixed rate payer with semiannual payments – pays 7.0% and gets 6 month LIBOR investor earns 85bp over LIBOR if no default investor has created synthetic floating-rate bond

6. Total Return Swap swap where one party makes periodic floating-rate payments to counterparty in exchange for the total return realized on a reference obligation  total return index swap  total return receiver – exposed to credit and interest rate risk  total return payer

7. Total Return Swap Example portfolio manager thinks Izzo’s fortunes will improve and credit spread relative to Treasury will decline over next year used to increase exposure to reference obligation Izzo issued 10 year bond at par with 9% coupon when Treasury is 6.2% - credit spread to Treasury? what can manager do if she believes spread declines?  total return swap as receiver with reference obligation of Izzo bond issue – semiannual payments – receiver pays 6 month Treasury + 160bp – notional $10m over one year  6 month Treasury starts at 4.8%  rate for computing second semiannual payment is 5.4%  at the end of year 1, 9 year Treasury rate is 7.6%  at the end of year 1, credit spread for reference obligation is 180bp

8. Total Return Swap Example first swap payment is 3.2% (4.8% + 160bp divided by 2) * notional second swap payment is 3.5% (5.4% + 160bp divided by 2) * notional payments received by manager are coupon payment (9%*10m) and change in value of reference obligation which will sell to yield (7.6% + 180=9.4%) - find price of this bond portfolio manager must make payment of $9,000

9. Total Return Swaps benefits  receiver does not have to finance purchase of reference assets  receiver can get same economic exposure to diversified basket of assets in one swap transaction that would otherwise take several cash market transactions  investor can use total return swap to short a corporate bond – action that is otherwise difficult disadvantage  return to receiver is dependent on both credit risk (declining or increasing credit spreads) and market risk (declining or increasing market rates) credit-independent market risk credit-dependent market risk

10. Credit Default Swaps most commonly used stand-alone product of group  simplest form so others (credit default options) rarely used used to shift credit exposure to a credit protection seller  purpose is to hedge credit exposure to a specific asset or issuer single name credit default swap basket credit default swap credit default swap index buyer pays fee to protection seller in return for right to receive payment conditional upon occurrence of credit event by reference obligation or reference entity  protection seller must pay if credit event occurs

11. Credit Default Swaps interdealer market for single-name credit default swaps  swaps for corporate and sovereign entities are standardized  some custom agreements  typically 5 years settlement  cash or physical delivery payment by protection seller – predetermined or based on change in value of reference obligation  amount of payment can be set or may be determined after credit event

12. Single-Name Credit Default Swaps reference entity is XYZ Corp. and underlying is $10m par of XYZ bonds swap premium is 200bp – calls for quarterly payment of premium  quarterly payment determined using day count convention of actual/360  assume there are 92 days in quarter and premium is 200bp on $10m  if no credit event, protection buyer makes quarterly payments over life of swap – if credit event occurs: no more payments of swap premium by protection buyer to seller termination value is determined for swap – with physical settlement there are issues called deliverable obligations

13. Single-Name Credit Default Swaps

14. uses by portfolio managers:  obtain exposure to reference entity using swap market instead of cash market because more liquid do this by selling protection and receiving a swap premium  difficult to sell currently held bond that has credit concern buy protection in swap market  if manager believes issuer will soon have trouble, shorting bond would be best but hard to short bond enter into swap as protection buyer  manager who wants a leveraged position in a corporate bond economically, a position of a protection buyer is equal to leveraged position in corporate bond

15. Basket Credit Default Swaps must specify when a payment needs to be made because they can be structured different ways  first-to-default basket swap  second-to-default basket swap cash settlement most common

16. Credit Default Swap Index credit risk of standardized basket of reference entities is transferred swap premium is paid but if credit event occurs, the swap premium payment continues but amount of payment is reduced (because notional amount of reference entity is reduced) uses by portfolio manager  help adjust exposure to a credit sector of bond market index increase exposure to credit sector by entering as protection seller decrease exposure by entering as protection buyer