Hellenic CFA Society Professional Development Series

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Hellenic CFA SocietyProfessional Development
Series
Credit Derivatives and Structured CreditTools,
Challenges and Market Opportunities Dimitris
Bakolas, Eurobank EFG Thodoris Sazaklis, Eurobank
EFG 12/03/2007
As a participant in the CFA Institute
Approved-Provider Program, the Hellenic CFA
Society has determined that this event qualifies
for credit for the CFA Institute Professional
Development Program. Eligible for 1 hour PD
Credit
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Credit Derivatives and Structured CreditTools,
Challenges and Market Opportunities

• Dimitris Bakolas, Eurobank EFG
• Thodoris Sazaklis, Eurobank EFG

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Presentation Outline

• Single Name Instruments and Strategies
• Credit Default Swaps
• Credit Curves
• Options on CDS
• Basis (Cash vs. Derivatives)
• FTD Baskets
• Portfolio Instruments and Strategies
• Credit Indices
• Options on Indices
• Credit Tranches
• Correlation

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Single Name Instruments and Strategies
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Flows of a Credit Default Swap
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Flows of a risky bond
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Credit Default Swaps

• A Credit Default Swap is an agreement in which
  one party buys protection against losses
  occurring due to a credit event of a reference
  entity up to the maturity date of the swap.
• The protection buyer pays a periodic fee for this
  protection up to the maturity date, unless a
  credit event triggers the contingent payment.
• If such a trigger happens, the buyer of
  protection only needs to pay the accrued fee up
  to the day of the credit event and deliver an
  obligation of the reference credit in exchange
  for the protection payout.

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What is a Credit Event?

• Failure to Pay
• Reference Entity fails to make an aggregate
  payment 1mm on an Obligation
• Bankruptcy
• Reference Entity voluntarily or involuntarily
  files for bankruptcy or insolvency protection
• Restructuring
• Reference Entity agrees to or announces a change
  in the terms of an Obligation 10mm as a result
  of deterioration in financial condition of the
  Reference Entity Subject to some variation
  depending on market
• Modified/Modified Modified restructuring
• Intended to overcome weaknesses with original
  definition. Places limitations on maturity of
  deliverable securities when Restructuring has
  been the effective credit event. Applies in the
  US and Europe respectively (typically excluding
  high-yield)

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What is an Obligation

• In a CDS, there are 2 types of Obligations
• Obligations that trigger a Credit Event (e.g. a
  failure to pay on a specific bond or loan)
• Deliverable Obligations are the assets that can
  be delivered if a Credit Event has occurred
• 6 categories
• Payment
• Borrowed money
• Bond or Loans
• Bonds
• Loans
• Reference Obligation only (predefined Obligation)

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Settlement of a CDS in case of Default
Physical Settlement
Cash Settlement

• Most common form of settlement
• Protection owner delivers the obligation in
  return for par
• Must be a Deliverable Obligation (an Obligation
  with certain characteristics)
• Borrowed Money, Bond or Loan, etc
• Additional qualifiers (Characteristics) as
  described before

• Much less common in the market, but sometimes
  used for specific reasons
• Generally, settlement amount is Par Recovery
• Recovery is valued in the market by asking
  dealers for firm all-in bid prices for the
  Reference Obligation or Deliverable Obligation
• Can also be a fixed amount such as Par. This is
  called digital, binary payout, or fixed recovery

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Example France Telecom (A3 / A-) Credit Default
Swaps Curve
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France Telecom Bonds Curve
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France Telecom 5 yr CDs Time Series
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Typical Trades involving CDs

• Portfolio hedging and / or yield enhancement
• Position ahead of prospect of default (timing and
  recovery)
• Play widening / tightening of spreads
• Play steepening / flattening of curves
• Play the bond / CDS basis
• Play senior / subordinated basis
• View on capital structure, i.e., credit vs.
  equity
• Play the out performance / under performance of a
  name vs. another name or vs. an index
• Macro views, i.e., investment grade vs. high
  yield names or portfolios
• Views on credit volatility
• Leveraged Credit Linked Notes

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Market Participants

• Market Makers, i.e., Dealers / Brokers
• Banks and loan portfolio managers
• Hedge Funds
• Asset Managers
• Insurance Companies
• Corporates

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CDS options

• CDS options are written on either a single-name
  or a credit index. There are two types of CDS
  options
• Payers are the right to buy protection at a
  specific spread level.
• Receivers are the right to sell protection at a
  specific spread level.
• An option on a single-name contract knocks out if
  the underlying credit defaults. Therefore, the
  option only provides protection against spread
  risk but not default risk.

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Option Pay-offs
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First to Default Baskets
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Portfolio Instruments and Strategies
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Credit Portfolios

• Customized / Bespoke Portfolios
• European Standardized Portfolios (iTraxx)
• Main, Crossover and HiVol
• US Standardized Portfolios (CDX)
• Main, Crossover, HiVol and High Yield
• Asian Standardized Portfolios
• iTraxx Japan, Rest Asia, Australia
• CDX Emerging Markets

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Standardized Portfolios / Indices

• Easy and quick to execute
• Easy to ramp up big positions
• Tight bid-offer spreads
• Easy to MTM positions
• Easy to get complex diversified synthetic
  positions
• Easy to evaluate relative-value managers

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iTraxx Family of Indices

• iTraxx and CDX have become the most liquid
  instruments in the credit universe
• iTraxx main includes the 125 most liquid European
  names in the CDs market (equally weighted)
• iTraxx Crossover includes the 50 most liquid
  European High Yield credits
• iTraxx HiVol contains the 30 names (from the 125)
  with the highest CDs spread at initiation
• All indices are defined / rebalanced every six
  months (every March and September) by the results
  of a dealers poll

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Simple Cash-Flow Collateralized Debt Obligation
(CDO)
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Collateralized Debt Obligations
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Origins of the Synthetic CDO business model
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Single Tranche Products
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Mechanics of Single-Tranche CDO
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Benefits of Synthetic CDOs

• Relative value in spread
• Shorter bullet maturities
• Efficient liability pricing
• Investment-grade portfolios
• Accelerated portfolio accumulation
• Flexible structures e.g. single-tranche CDOs
• Pure credit risk
• Smooth execution
• Market access

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Capital Structure / Tranches
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IRR for SR and AAA tranches
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IRR for mezzanine equity tranches
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B/E Cumulative Default Summary
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European iTraxx S6 Tranches
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iTraxx S6 Equity Tranches
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iTraxx Tranches Compound and Base Correlation

• Compound and base correlation are market implied
  parameters. They measure the default correlation
  in the underlying basket
• Compound correlation refers to a specific
  tranche, e.g. 6-9
• Base correlation refers to the corresponding
  equity tranche, e.g. 0-9
• Correlation smile characteristic shape of the
  compound correlation curve