Credit Derivatives I

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Credit Derivatives I
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Motivation
Pension Fund (CalPERS) needs to invest in AA
quality per guidelines, say 1B
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Another picture
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The credit derivative market per OCC
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The credit derivative market per OCC
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OCCs full breakdown of the market
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Some Acronymns

• CDO Collateralized Debt Obligation
• A bond that repackages the cash flows from
  another set of assets. For example, a CMO is a
  CDO.
• CMO Collateralized Mortgage Obligation
• A CDO where the set of assets is comprised solely
  of mortgage loans (also called an MBB)
• MBB Mortgage Backed Bonds
• CDS Credit Default Swap
• Essentially put options on a CDO or other issue
  subject to credit risk

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CDOs

• CDO created by pooling returns of some set of
  assets, and then issuing claims on various parts
  of the pool (portfolio).
• CDO claims are typically tranched
• tranche meansslice in French
• Tranches vary by payoff priority (creating Aa to
  junk)
• Individual high-risk bonds can be combined to
  create safe tranches and very risky tranches
  (arbitrage CDOs)

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Figure 27.5 Hypothetical CDO
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CDO (MBB) structure

• Even if some mortgages in pool are subprime, note
  that the pooler can create some AAA debt out of
  subprime loans assuming little to zero
  correlation risk of default!
• Note that the B, BB and BBB CDO can be re-pooled,
  created CDO2

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Tranche payoff

• If there is enough money left in the pool
• Then the tranche gets paid!
• A maturity value of entire pool
• Bi promised payoff of bond in ith tranche
• (Eq 27.16)

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Credit Risk

• Credit risk is the risk that a counterparty will
  fail to meet a contractual payment obligation
• Most commonly, credit risk is the possibility
  that a borrower will declare bankruptcy
• To deal with credit risk firms/investors can use
• credit-based derivatives, such as credit default
  swaps, that pay when a firm defaults. Thus, they
  effectively permit the trading of default risk
• derivative pricing models can be adapted for
  modeling default

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Credit Risk (contd)

• Classic tools for investors to deal with
  bankruptcy
• diversification across borrowers,
• collateral requirements, and
• statistical tests based on borrower
  characteristics designed to predict the
  likelihood of bankruptcy
• Since 1990s credit derivative market develops

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The Structure of a Credit Default Swap

• CDSs are not swaps as weve defined to date.
• They are put options with a periodic payment plan
• Note that the Investor need not be an owner of
  the reference asset
• They could just speculate on default risk
• Figure 27.1

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Analogy CDS as Auto Insurance
What is the biggest difference between auto
insurance and credit insurance?
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CDS on CDOs
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The Structure of a Default Swap (contd)

• If there is an actual default, the default swap
  could settle either financially or physically
• In a financial settlement, the swap writer would
  pay the bondholder the value of the loss on the
  bond. The bondholder would continue to hold the
  defaulted bond
• (typical arrangement)
• In a physical settlement, the swap writer would
  buy the defaulted bond at the price it would have
  in the absence of default
• Note that there is still credit risk in the
  default swap. The default swap buyer faces the
  possibility that the swap writer will go bankrupt
  at the same time as a default occurs on the
  reference asset (think AIG)

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Pricing a Default Swap

• How is the premium on a default swap determined?
• A simple argument suggests that the default swap
  premium (spread) should equal the difference
  between the yield on the reference asset and the
  yield on an otherwise equivalent default-free
  bond
• In other words, the default swap premium equals
  the credit spread

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BRK 5-year CDS spreads
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Credit Default Swap Indices

• A credit default swap index is an average of the
  premiums on a set of CDSs
• A CDS index provides a way to track the overall
  market for credit
• It is possible to replicate a CDS index by
  holding a pool of CDSs

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Pooling CDSs

• There are many ways in which a CDS index product
  can be structured and traded
• The CDS claims are generally tranched in various
  ways, for example, simple priority or Nth to
  default
• Therefore, CDOs can be created using CDSs
• You could now invest in a CDO (which is a pool of
  CDSs), and then insure that with another CDS

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Engineers creating markets

• Creation of CDS indices allows firms to create
  more demand for CDSs
• You could now invest in a CDO (which is a pool of
  CDSs), and then insure that with another CDS
• Debts (pooled)?CDO ? CDSs, (pooled) ?CDOs of CDSs
  ? CDSs
• The underlying can be any debt instrument

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International CDS Indices (pooled CDSs)