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Zvi Wiener

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Credit Default Swap ... buyer (A) enters a 1-year credit default swap on a notional of $100M worth of ... and makes a short position in a credit default swap. ... – PowerPoint PPT presentation

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Title: Zvi Wiener


1
Financial Risk Management
  • Zvi Wiener
  • Following
  • P. Jorion, Financial Risk Manager Handbook

2
Chapter 22Credit Derivatives
  • Following P. Jorion 2001
  • Financial Risk Manager Handbook

3
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.

4
Credit Derivatives
  • Bond insurance
  • Letter of credit
  • Credit derivatives on organized exchanges
  • TED spread Treasury-Eurodollar spread
  • (Futures are driven by AA type rates).

5
Types of Credit Derivatives
  • Underlying credit (single or a group of
    entities)
  • Exercise conditions (credit event, rating,
    spread)
  • Payoff function (fixed, linear, non-linear)

6
Types of Credit Derivatives
  • November 1, 2000 reported by Risk
  • Credit default swaps 45
  • Synthetic securitization 26
  • Asset swaps 12
  • Credit-linked notes 9
  • Basket default swaps 5
  • Credit spread options 3

7
Credit Default Swap
  • A buyer (A) pays a premium (single or periodic
    payments) to a seller (B) but if a credit event
    occurs the seller (B) will compensate the buyer.

B - seller
A - buyer
Reference asset
8
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.
  • At the beginning of the year A pays 500,000 to
    the seller.
  • Assume there is a default of XYZ bond by the end
    of the year. Now the bond is traded at 40 cents
    on dollar.
  • The protection seller will compensate A by 60M.

9
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

10
Total Return Swap (TRS)
  • Protection buyer (A) makes a series of payments
    linked to the total return on a reference asset.
    In exchange the protection seller makes a series
    of payments tied to a reference rate (Libor or
    Treasury plus a spread).

11
Total Return Swap (TRS)
B - seller
A - buyer
Reference asset
12
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 LIBOR9 and by the end of the year
    the value of the bond drops from 100 to 95M.
  • The bank has to pay 10M-5M5M and will receive
    in exchange 90.5M9.5M

13
Credit Spread Forward
  • Payment (S-F)DurationNotional
  • S actual spread
  • F agreed upon spread
  • Cash settlement
  • May require credit line of collateral
  • Payment formula in terms of prices
  • Payment P(yF, T)-P(yS,T)Notional

14
Credit Spread Option
  • Put type
  • Payment Max(S-K, 0)DurationNotional
  • Call type
  • Payment Max(K-S, 0)DurationNotional

15
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 61.87.8 is 101.276.
  • The price of the same bond discounted at
    61.67.6 is 102.574.
  • The payout is (102.574-101.276)/100100M
    1,297,237

16
Credit Linked Notes (CLN)
  • Combine a regular coupon-paying note with some
    credit risk feature.
  • The goal is to increase the yield to the investor
    in exchange for taking some credit risk.

17
CLN
A buys a CLN, B invests the money in a high-rated
investment and makes a short position in a credit
default swap. The investment yields LIBORYbp, th
e short position allows to increase the yield by
Xbp, thus the investor gets LIBORYX.
18
Credit Linked Note
CLN AAA note Credit swap
Credit swap buyer
investor
AAA asset
Asset backed securities can be very dangerous!
19
Types of Credit Linked Note
  • Type Maximal Loss
  • Asset-backed Initial investment
  • Compound Credit Amount from the first default
  • Principal Protection Interest
  • Enhanced Asset Return Pre-determined

20
FRM 1999-122 Credit Risk (22-4)
  • A portfolio manager holds a default swap to hedge
    an AA corporate bond position. If the
    counterparty of the default swap is acquired by
    the bond issuer, then the default swap
  • A. Increases in value
  • B. Decreases in value
  • C. Decreases in value only if the corporate bond
    is downgraded
  • D. Is unchanged in value

21
FRM 1999-122 Credit Risk (22-4)
  • A portfolio manager holds a default swap to hedge
    an AA corporate bond position. If the
    counterparty of the default swap is acquired by
    the bond issuer, then the default swap
  • A. Increases in value
  • B. Decreases in value it is worthless (the same
    default)
  • C. Decreases in value only if the corporate bond
    is downgraded
  • D. Is unchanged in value

22
FRM 2000-39 Credit Risk (22-5)
  • A portfolio consists of one (long) 100M asset
    and a default protection contract on this asset.
    The probability of default over the next year is
    10 for the asset, 20 for the counterparty that
    wrote the default protection. The joint
    probability of default is 3. Estimate the
    expected loss on this portfolio due to credit
    defaults over the next year assuming 40 recovery
    rate on the asset and 0 recovery rate for the
    counterparty.
  • A. 3.0M
  • B. 2.2M
  • C. 1.8M
  • D. None of the above

23
FRM 2000-39 Credit Risk
  • A portfolio consists of one (long) 100M asset
    and a default protection contract on this asset.
    The probability of default over the next year is
    10 for the asset, 20 for the counterparty that
    wrote the default protection. The joint
    probability of default is 3. Estimate the
    expected loss on this portfolio due to credit
    defaults over the next year assuming 40 recovery
    rate on the asset and 0 recovery rate for the
    counterparty.
  • A. 3.0M
  • B. 2.2M
  • C. 1.8M 1000.03(1 40) only joint default
    leads to a loss
  • D. None of the above

24
FRM 2000-62 Credit Risk (22-11)
  • Bank made a 200M loan at 12. The bank wants to
    hedge the exposure by entering a TRS with a
    counterparty. The bank promises to pay the
    interest on the loan plus the change in market
    value in exchange for LIBOR40bp. If after one
    year the market value of the loan decreased by 3
    and LIBOR is 11 what is the net obligation of
    the bank?
  • A. Net receipt of 4.8M
  • B. Net payment of 4.8M
  • C. Net receipt of 5.2M
  • D. Net payment of 5.2M

25
FRM 2000-62 Credit Risk (22-11)
  • Bank made a 200M loan at 12. The bank wants to
    hedge the exposure by entering a TRS with a
    counterparty. The bank promises to pay the
    interest on the loan plus the change in market
    value in exchange for LIBOR40bp. If after one
    year the market value of the loan decreased by 3
    and LIBOR is 11 what is the net obligation of
    the bank?
  • A. Net receipt of 4.8M (12-3)
    (110.4)200M
  • B. Net payment of 4.8M
  • C. Net receipt of 5.2M
  • D. Net payment of 5.2M

26
Pricing and Hedging Credit Derivatives
  • 1. Actuarial approach historic default rates
  • relies on actual, not risk-neutral probabilities
  • 2. Bond credit spread
  • 3. Equity prices Mertons model

27
Example Credit Default Swap
  • CDS on a 10M two-year agreement.
  • A protection buyer agrees to pay to
  • B protection seller a fixed annual fee in
    exchange for protection against default of 2-year
    bond XYZ.
  • The payout will be Notional(100-B) where B is
    the price of the bond at expiration, if the
    credit event occurs.
  • XYZ is now A rated with YTM6.6, while T-note
    trades at 6.

28
Actuarial Method
  • 1Y 1 probability of default
  • 2Y 0.010.900.020.070.050.021.14

29
Actuarial Method
  • 1Y 1 probability of default
  • 2Y 0.010.900.020.070.050.021.14
  • 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)
30
Credit Spread Method
  • Compare the yield of XYZ with the yield of
    default-free asset. The annual protection cost
    is
  • Annual Cost 10M (6.60-6) 60,000

31
Equity Price Method
  • Following the Mertons model (see chapter 21) the
    fair value of the Put is

The annual protection fee will be the cost of Put
divided by the number of years.
To hedge the protection seller would go short the
following amount of stocks
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