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Zvi Wiener
Following
P. Jorion, Financial Risk Manager Handbook
http://pluto.huji.a
c.il/~mswiener/zvi
FRM
972-2-588-3049
Chapter 22
Credit Derivatives
Following P. Jorion 2001
Financial Risk Manager Handbook
http://pluto.huji.a
c.il/~mswiener/zvi
FRM
972-2-588-3049
Credit Derivatives
From 1996 to 2000 the market has grown from
$40B
to
$810B
Contracts that pass credit risk from one counterparty to
another. Allow separation of credit from other exposures.
Ch. 22, Handbook
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Credit Derivatives
Bond insurance
Letter of credit
Credit derivatives on organized exchanges:
TED spread = Treasury-Eurodollar spread
(Futures are driven by AA type rates).
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45%
Synthetic securitization
26%
Asset swaps
12%
Credit-linked notes
9%
5%
3%
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A - buyer
Contingent payment
B - seller
Reference asset
Ch. 22, Handbook
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Example
The protection buyer (A) enters a 1-year credit
default swap on a notional of $100M worth of 10-year
bond issued by XYZ. Annual payment is 50 bp.
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Types of Settlement
Lump-sum fixed payment if a trigger event occurs
Cash settlement payment = strike market value
Physical delivery you get the full price in exchange
of the defaulted obligation.
Basket of bonds, partial compensation, etc.
Definition of default event follows ISDAs Master
Netting Agreement
Ch. 22, Handbook
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B - seller
A - buyer
Payment tied to reference rate
Reference asset
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Example TRS
Bank A made a $100M loan to company XYZ at a fixed rate
of 10%. The bank can hedge the exposure to XYZ by entering
TRS with counterparty B. The bank promises to pay the
interest on the loan plus the change in market value of the loan
in exchange for LIBOR + 50 bp.
Assume that LIBOR=9% and by the end of the year the value
of the bond drops from $100 to $95M.
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Example
A credit spread option has a notional of $100M with a maturity of
one year. The underlying security is a 8% 10-year bond issued by
corporation XYZ. The current spread is 150bp against 10-year
Treasuries. The option is European type with a strike of 160bp.
Assume that at expiration Treasury yield has moved from 6.5% to
6% and the credit spread widened to 180bp.
The price of an 8% coupon 9-year semi-annual bond discounted at
6+1.8=7.8% is $101.276.
The price of the same bond discounted at 6+1.6=7.6% is $102.574.
The payout is (102.574-101.276)/100*$100M = $1,297,237
Ch. 22, Handbook
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CLN
A buys a CLN, B invests the money in a highrated investment and makes a short position in a
credit default swap.
The investment yields LIBOR+Ybp, the short
position allows to increase the yield by Xbp, thus
the investor gets LIBOR+Y+X.
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par
CLN =
Xbp
AAA note +
L+X+Y
Credit swap
Contingent payment
par
investor
Contingent payment
LIBOR+Y
AAA asset
Asset backed securities can be very dangerous!
Ch. 22, Handbook
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Maximal Loss
Initial investment
Amount from the first default
Interest
Pre-determined
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Actuarial Method
Starting
State
A
B
C
D
Ending state
A
B
C
0.90 0.07 0.02
0.05 0.90 0.03
0
0.10 0.85
0
0
0
Total
D
0.01
0.02
0.05
1.00
1.00
1.00
1.00
1.00
1Y 1% probability of default
2Y: 0.01*0.90+0.02*0.07+0.05*0.02=1.14%
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Actuarial Method
1Y 1% probability of default
2Y: 0.01*0.90+0.02*0.07+0.05*0.02=1.14%
If the recovery rate is 60%, the expected costs are
1Y: 1%*(100%-60%) = 0.4%
2Y: 1.14%*(100%-60%) = 0.456%
Annual cost (no discounting):
1% 1.14%
$10 M
(100% 60%) $42,800
2
Ch. 22, Handbook
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Put V N (d1 ) Ke
rT
N (d 2 )
Put V
1
1
V S
N (d1 )
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