Derivatives Credit Derivatives

Structured Products
Credit Derivatives
Copyright © 1998-2006
Investment Analytics
Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 1

Credit Derivatives
¾ Credit Risk
¾ Credit Assets
¾ Credit Derivatives
¾ Applications

Credit Risk
¾ Default Risk
• Loan not repaid in full
¾ Downgrade Risk
• Rating agency reduces debtor’s credit rating
• Reduces value of debt
¾ Credit Spread Risk
• If credit deteriorates, spread relative to base
index will widen

Credit Risk
¾ Future bond cash flows not certain - risk of default
¾ Risk measured by rating agencies
• Moody’s Investor Services
• Standard & Poor’s Corp.
¾ Rating Scales:
Moody’s S&P
Aaa AAA Highest quality debt.
Aa AA
A A
Baa BBB Min. investment grade
Ba - D BB - D High Yield (“Junk”)
Credit as an Asset
¾ Portfolio of Credits can be segregated

into baskets of loans
¾ Portfolio manager uses credit
derivatives to:
• enhance yields
• diversify credit holdings

Rationale for Credit Derivatives:
Credit Risk and Cost of Capital
• Spread compensates for expected and unexpected loss
• Spread should fund the loan loss reserve and provide adequate
return on capital/reserve
expected loss = probability of default x (1 - recovery rate)

Frequency of Occurence
unexpected loss = volatility x (1 - recovery rate)
3 standard deviations of loss

Loss ($mm)
50 500
Spread = (1 - recovery rate)[expected default rate + return on capital]

Rationale for Credit Derivatives: Risk
Adjusted Return
130
Decrease exposure
¾ Growing exposure 120
demands increased spread 110
to satisfy return on risk 100
Constant return on risk
Spread (bp)
requirement 90
80
Market spread
70
¾ Analysis helps identify 60
credit constraints and 50
Increase exposure
opportunities 0.1 0.5 1 2 5 10

Exposure (%)
¾ Active management of
credit portfolio is key
Dynamic Management of Credit Risk
Tolerance Level
Exposure or Risk
Sell Credit Derivative or Loan
Time

Rationale for Credit Derivatives
¾ Continuing and growing need for funding

¾ Managing reserve requirements & other constraints
¾ Enhancing credit characteristics of existing products &
portfolios
¾ Pricing credit risk
¾ Credit risk and cost of capital
¾ Risk adjusted return

Applications
¾ Credit risk = default risk + credit spread risk
¾ Credit derivatives allow transfer of:
• Default Risk
• Credit Spread Risk
¾ Reasons:
• Risk mitigation
• Investment
• Diversification

Asset management examples
¾ Hedging
• Transfer default risk in a confidential manner
• Investor can short in new markets
¾ Replacement of cash assets
• Leverages return vs cash investment
• Rescue structures
¾ Tax/accounting management
• Can defer/eliminate capital gains and
withholding taxes
Defining credit derivatives
¾ Financial contracts with a payout linked to:
• Loan or bond values
• Default or credit events
• Credit spreads
• Credit ratings
¾ Cash settled, or delivery of underlying
¾ On single names, baskets, indices
¾ Delivery as notes or OTC contracts
¾ Delivery as swaps or options
Basic structures
¾ First generation
• Total return swap
• Default swap
• Default digital
¾ Second generation
• Floating rate asset derivatives
• Fixed coupon asset derivatives
• Rating option
¾ Third generation exotics
Total Return Swap
• Party A pays total return on underlying asset
(including interest and capital appreciation)
• Party B pays funding payment (LIBOR + x%)
plus any capital depreciation
• Bank A removes credit risk without selling the
underlying
Total Return
A B
LIBOR + x% + any
capital depreciation
Default Swap
• Bank A pays default premium x b.p. until default
• Bank B pays agreed notional amount on default
(relative to underlying reference loan or security)
• B assumes credit risk from A
• Bank A can factor cost of the swap into loan loan
and removes credit risk of a valued customer
X b.p. up to default
A B
$Y on default
Limited Recourse Note
¾ This is a bond whose coupons are linked to

defaultable underlying assets S1 and S2
¾ Coupon is contingent:
• X1% until default of S1 or S2
• X2% after first default
• X3% after 2nd default

Credit Spread Option
• Pays N[S-K]+ at maturity

where S is the yield spread between the underlying
security and US Treasury
K is an agreed strike level,
N is notional.
• This is a straight play on movement of credit

spreads.

Credit Swaps: Applications
¾ Single risk transfer

• transfer exposure to single credit
¾ Dual risk transfer
• exchange of pair of credits
¾ Yield enhancement
¾ Gaining market exposure

Credit Swap: Single Risk Transfer
¾ Hedge default risk
¾ Diversify portfolio
LIBOR + 20bp
Bank Portfolio
Manager
Leveraged Co.
debt payments

Using Credit Swaps to Gain Exposure
¾ Fund wants high yield investment

• Emerging markets
¾ Problem: investment restrictions

• Typical: can’t invest below BBB grade debt

Emerging Market Credit Swap -
Example
Fixed coupon 7%
Bank Portfolio
Manager
Korean loan
yield 8.25%

Credit Leverage
¾ Set NP to desired leverage level
• Previous example: 125 bp spread on $1MM
portfolio
• Set swap NP to $10MM: spread is now worth
12.5%
• If credit deteriorates loss is also greater!!

Credit Options
¾ Allow trading or hedging of changes in credit
quality
¾ Put options
• Right to sell credit (spread) at specified strike price
¾ Call options
• Right to purchase credit (spread) at specified strike
price
¾ Typically achieved by purchasing bond options

• Put option on bond = call option on yield spread
Credit Option - Example
¾ Portfolio manager holds LDC debt
• Wants protection against falling credit values
¾ Purchases put option on Argentinian govt. bond
• Bond has 5 year term, duration 3.2
• Strike price, X = 100 bp spread
• Premium = 75bp
¾ Later: spread widens to S = 128
¾ Option payoff: Duration x (S - X)
• 3.2 x (128 - 100) = 89.6 bp
• Net gain: ~ 14.6bp
Exotic Credit Options
¾ Barrier and digital options common
¾ Example:
• Portfolio manager bullish on Mexican debt
• Seeks to profit from narrowing credit spread
• Purchases up-and-out put on credit spread

Up and Out Credit Put
3.5 Strike = Floating + 30

3.0
2.5
2.0
1.5
1.0
0.5
Credit Spread
0.0
0 10 20 30 40 50 60
barrier = 40 bp

Other Credit Derivatives
¾ Credit spread caps
• Locks in maximum spread on borrowings
¾ Asset backed notes
• Bundle of non-investment grade credits
¾ Principal protected notes
• Offer up to 100% protection of principal
¾ Basket instruments
• Hard to price
¾ Credit index instruments
• Not yet widely traded

Derivatives Credit Derivatives

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Derivatives Credit Derivatives

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Structured Products

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 1

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 2

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 3

¾ Portfolio of Credits can be segregated

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 5

expected loss = probability of default x (1 - recovery rate)

unexpected loss = volatility x (1 - recovery rate)

3 standard deviations of loss

Spread = (1 - recovery rate)[expected default rate + return on capital]

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 6

opportunities 0.1 0.5 1 2 5 10

Sell Credit Derivative or Loan

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 8

¾ Continuing and growing need for funding

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 9

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¾ This is a bond whose coupons are linked to

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• Pays N[S-K]+ at maturity

• This is a straight play on movement of credit

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¾ Single risk transfer

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¾ Fund wants high yield investment

¾ Problem: investment restrictions

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• If credit deteriorates loss is also greater!!

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 22

¾ Typically achieved by purchasing bond options

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 25

3.5 Strike = Floating + 30

Copyright © 1998-2006 Investment Analytics Credit Derivatives Slide: 26

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