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

• 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• 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adverse for creditors)• Repayment Acceleration on Default• Repudiation • (sovereign only – indication that a debt is no longer valid)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 ExamplePayoff from a Credit Default Swap

•Bank A holds a corporate bond issued by C•Reference asset Bond C, maturing in two years•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 ExamplePayoff 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 ExamplePayoff 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 ExamplePayoff from a Credit Default Swap

• The payoff on default will be calculated as follow• P= Notional principal x Par Value – Market Value

100

•Bank B makes payment to Bank A•USD 10,000,000 x (100–48.63)/100 =USD 5,137,000Net 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•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 Bank A

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 ctd.

• 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 ctd.• 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