credit derivatives 2003 – notional value $2.31 trillion investment grade bonds - $3.1 trillion

59
Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Upload: clemence-burns

Post on 23-Dec-2015

221 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Credit Derivatives

2003 – Notional value $2.31 trillion

Investment grade bonds - $3.1 trillion

Page 2: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Purposes

• Transfer and repackaging of credit risk

• Default baskets and synthetic loss tranches– New exposure to credit risk to leverage credit

risk

Page 3: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Credit Derivatives Market

• $2.306 trillion notional value in 2003 was a 50% increase from 2002

• Credit default swaps - 73%

• Correlation products – Synthetic loss tranches and default baskets – 22%

• U.S companies – 43.8%

• European – 40.1%– U.S. has a much larger cash market

Page 4: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Banks – 50%– Hedging and diversification

• Insurance companies – 14%

• Hedge funds – 13%

Page 5: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Credit Default Swaps

• Bilateral contract to transfer credit risk of a reference entity from one party (protection buyer) to another party (protection seller)

• Protection buyer – shorting credit risk

• Protection buyer makes regular payments (usually quarterly) know as the premium leg until credit event or maturity

Page 6: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Default swap mechanics

If a default occurs, there is a cash settlement or physical settlement

Page 7: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion
Page 8: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Pari Passu

• From Wikipedia, the free encyclopedia• pari passu is a Latin phrase that means "at the same

pace", and by extension also "fairly", "without partiality".• In finance this term refers to two or more loans, bonds or

series of preferred stock having equal rights of payment, i.e., have the same level of seniority. In asset management firms, the term denotes an equal allotment of trades to strategically identical funds or managed accounts.

• This term is also often used in bankruptcy proceedings where creditors are said to be paid 'pari passu', or each creditor is paid pro rata in accordance with the amount of his claim. Here its meaning is 'equally and without preference'.

Page 9: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Physical settlement – most common– Requires protection buyer deliver notional

amount to the seller for notional amount paid in cash. Generally, the deliverable instrument is a basket with restrictions on maturity and pari passu. The buyer is long a “cheapest-to-deliver” option.

Page 10: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Cash settlement – not generally used in CDS, but is common in default baskets and synthetic CDOs

Page 11: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

CDS Maturity

• Maturity tends to be one of 4 roll dates– 20th of March, June, September, and

December

• New contract 5-year contract on April 12th 2004 will mature June 20th 2009

• Assume contract has a spread of 160 bp

• Convention is Actual/360

• Default occurs on August 18, 2005

Page 12: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• $10 million notional value

• Assume contract has a spread of 160 bp

• Convention is Actual/360

• Default occurs on August 18, 2005

• Cash price of deliverable asset = $34

Page 13: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

CDS Cash Flow

Date

Cash flow to protection seller

July 23, 2004 $40,444.44

October 25, 2004 $41,777.78

January 24, 2005 $40,444.44

April 24, 2005 $40,444.44

July 25, 2005 $40,444.44

August 18, 2005 $10,222.22 – 6,600,000 = -$6,589,777.80

Page 14: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Uses of CDS

• Easy to short credit risk. Allows hedging of credit risk or for those with a bearish credit view.

• CDS are unfunded so leverage is possible.

• CDS are customizable in terms of maturity, seniority, and currency. Deviation from market standard may incur a liquidity cost.

Page 15: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• CDS can be used to take a spread view on credit. A CDS can be unwound to realize gains (or losses) owing to changes in credit spread,

• Liquidity can be better than the cash market. Most liquid is 5-year. 3-year, 7-year, and 10-year are less liquid.

Page 16: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• International Swaps and Derivatives Association (ISDA) has a master agreement. – Reduces legal risk, speeds up confirmation,

and therefore enhances liquidity.

• However, CDS market is not standardized. U.S, European, and Asian markets are segmented.

Page 17: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

ISDA Credit Events

• Bankruptcy – corporation becomes insolvent.

• Failure to pay – reference entity does not make due payments, taking into account a grace period to avoid administrative error.

• Restructuring – changes in the debt obligations of the reference creditor but excluding those that are not associated with credit deterioration, such as the renegotiation of more favorable crdit terms.

Page 18: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Obligation acceleration/obligation default – Obligations become due and payable earlier than they would have been due to default or similar condition.

• Repudiation/Moratorium – A reference entity or government rejects or challenges the validity of the obligations.

Page 19: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Restructuring Clause

• Following bankruptcy, pari passu assets should have the same recovery value.

• After a restructuring – Short term may have higher value than long-

term – High coupon bonds may be more valuable

than low coupon bonds– Loans are more valuable than bonds due to

covenants

Page 20: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• This makes a CDS valuable

• Consider a protection buyer with a hedge on short-term debt trading at $80 while long-term debt trades at $65. – Buy the CDS, buy the long-term bond, and

make delivery. An immediate $15 profit (at the expense of the protection seller).

• 2000 – Restructuring of Conseco

Page 21: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Old restructuring

• Original standard for which delivery is a bond with a maximum maturity of 30 years

Page 22: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Modified Restructuring (Mod-re)

• Current standard in U.S. Roughly speaking, it limits the maturity of the deliverable to the maturity of the CDS contract plus 30 months.

Page 23: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Modified-Modified-Restructuring (mod-mod-re)

• Current European standard. it limits the maturity of the deliverable to the maturity of the CDS contract plus 60 months. It also allows the delivery of conditionally transferable obligations rather than only fully transferable obligations.

Page 24: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

No restructuring

• Eliminates restructuring as a credit event.

Page 25: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Restructuring and Spread

• Contracts may be available with all four restructuring options.

• No-re will have tightest spread.

• Mod-re spread.

• Mod-mod-re more valuable than mod-re and will have next widest spread.

• Old-re should have widest spread

Page 26: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

CDS Formats

• Swap format (unfunded format)– No initial payment– Counterparty risk

• Credit-linked note (funded format)– Buyer has to buy fund the purchase of a high

credit quality bond– At maturity, the bond is returned to the buyer

Page 27: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Determining the CDS Spread

• Before credit event

Page 28: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Before credit event

• On the annual payment dates, hedged investor receives

+F – D – B

At maturity, buyer receives par from asset and repays borrowed amount

Page 29: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Determining the CDS Spread

• After credit event

Page 30: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

After credit event

• Buyer delivers the defaulted asst to seller in return for par and repays the funding loan with this principal (assume at par)

• Strategy has no initial cost and is flat following credit event, so CF before event have to equal zero

Page 31: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

No arbitrage condition

• D = F – B

• Par floater = LIBOR + 25bp

• Funding = LIBOR + 5bp

• F = 25bp

• B = 5bp

• D = 25bp – 5bp = 20bp

Page 32: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Not exact– Ignores accrued interest and coupon recovery– Also lacks adjustments for availability of cash,

liquidity, supply and demand, and counterparty risk

• Good starting point, and if incorrect by a lot, arbitrage may exist

Page 33: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Default Swap Basis

• CDS – unfunded proxy for cash bond• Divergence between CDS and cash bonds

is default swap basis– Default swap basis = CDS spread – cash

LIBOR spread

• Positive basis – cash bond spread inside CDS spread

• Negative basis – CDS spread inside cash LIBOR spread

Page 34: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Divergence between cash and CDS spread– Fundamental factors– Market factors

Page 35: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Fundamental Factors

• 1) Funding

• If buyer borrows cash to purchase a bond, and their credit quality is high, they may be able to issue below LIBOR. This means it may be better to buy bond than sell protection in CDS. If funding cost is above LIBOR, the reverse may be true.

Page 36: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• 2) The delivery option

• The cheapest to deliver option may be valuable, so long position in CDS is more valuable than short position. Widens CDS spread and increases basis.

Page 37: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• 3) CDS protects par

• Bonds can trade above or below par because of interest rates. Bonds with high (low) coupons exposes the to a greater (lower) credit risk. Bonds below par value should pay a lower spread than the CDS, bonds above par should pay a higher spread than default swaps.

Page 38: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• 4) Counterparty risk

• Protection buyers will pay a lower spread because of counterparty risk. Posting collateral can reduce this risk.

Page 39: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Market Factors

• 1) Technical short

• Hedging of synthetic loss tranches requires a significant amount of dealer hedging, reducing the basis.

Page 40: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• 2) Convertible issuance

• Convertible equity funds use CDS to hedge credit risk in convertibles. This drives default swap spreads higher since there are few outstanding convertible bonds. Widening is usually not sustained and reverts to normalized levels.

Page 41: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• 3) Demand for protection

• Negative view on credit can be traded in two ways - Bond can be sold short or CDS can be purchased. This can widen both cash and default swap spread. However, it is easier to do a CDS, so the widening of the spread is first observed in the CDS market.

Page 42: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

On October 22, 2001, Enron’s stock price dropped 20% to $20.65 per share, and five-year credit default swap (CDS) spreads jumped 20% to 48 basis points, after the Securities & Exchange Commission announced it was looking into the firm’s accounting practices. When Enron announced it had overstated profits by nearly $600m over five years on November 8, the stock was at $8.41 and CDS spreads were at 133bp. By the time Moody’s and S&P finally downgraded Enron to junk status on November 28, its stock was worth little more than a dollar per share. Bankruptcy was filed on December 2, 2001.

Page 43: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• The moral of the story, ‘don’t ignore the market’, was a hard lesson for the rating agencies to learn. Five years on, one agency, Moody’s, has something to show for it.

• Moody’s, the oldest rating agency, and alongside Standard & Poor’s one of the two largest agencies by market share, has developed a set of ratings indicators derived from market signals. These may be used as a counterpart to Moody’s ‘normal’ ratings, which are based on analysts’ views of an issuer’s creditworthiness.

• The indicators, dubbed ‘market implied ratings’ (MIR), highlight discrepancies between an issuer’s credit rating – in essence, the rating agency’s assessment of a company’s financial situation and future outlook – and the market’s view of that issuer – which is in effect the sum total of the expression of all bond, credit derivatives and equity investors’ views on that company.

Page 44: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

It might seem like something of a no-brainer that securities the market takes a dim view of are more likely to default; but what is surprising is the degree to which it is true. Using a data set of 2,900 issuers, with 180,000 observations gathered between January 1, 1999 and February 28, 2006, the one-year default rate for B2 rated issuers trading two notches below their Moody’s rating was a massive 17.82%. That compares with a default rate of 3.61% for issuers trading flat to their Moody’s rating; or 0.59% for those trading two notches rich. In other words, if you held a portfolio of bonds that were trading two notches cheaper than the Moody’s rating, you should expect nearly a fifth of them to default within a year.

Market implied ratings (MIR) can also be used to predict potential ratings changes. An issuer trading three notches below its Moody’s rating is looking at about a 25% chance of downgrade over a one-year horizon, according to MIR data from the same data set.

Page 45: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Valuing a CDS

• Value at inception is zero – no cost to enter

• Value will change over time

• At inception:– E(PV) protection leg = E(PV) premium leg

• Mark-to-market (MTM) value is the value the market would pay us to unwind the position

Page 46: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Suppose a 5-year CDS was issued at a 250bp spread. In one year, the spread on the reference entity falls to 100bp.

• MTM = E(PV) of premium leg of 250bp• - E(PV) of 4-year protection leg

• New 4-year CDS:• E(PV) of premium leg of 250bp• - E(PV) of 4-year protection leg

Page 47: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Substituting:

• MTM = E(PV) of premium leg of 250bp

• - E(PV) of 4-year premium pmts 100 bp

• MTM = E(PV) of premium leg of 150bp

Page 48: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Discount PV of 150bp payments. However, payments are made only until credit event, so:

• MTM = 150bp * RPV01RPV01 = risky PV01 of a 1bp paid on

the premium leg. Calculating the RPV01 requires a model that uses market spreads to determine probability of default.

Bloomberg – CDWS function

Page 49: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Basket Default Swaps(or default baskets)

• Synthetic correlation products that redistribute the risk of a portfolio of 5 to 200 CDS.

• Similar to a CDS, except that the nth credit event is the trigger. The first-to-default (FTD) basket takes the first defaults. Protection seller receives a spread based on the notional value until the nth credit event or maturity.

Page 50: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• A basket default swap exposes the protection seller to the tendency of the assets to default together, or default correlation.

Page 51: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Why?

• Consider a reference portfolio with CDS spreads of 30bp, 30bp, 27bp, 29bp, and 30bp. The FTD basket may pay 120bp. A more risk averse investor could take the second-to-default (STD) basket or lower.

Page 52: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Valuing a Default Basket

• Value of n – A FTD is riskier than a STD and commands a higher spread.

• Number of credits – The more credits in the basket, the greater the likelihood of one or more credit events, so the higher the spread.

• Credit quality – The lower the credit quality of the credits, the higher the spread,

Page 53: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Maturity – The effect of maturity depends on the shape the individual credit curves and the correlation of the term structure.

• Default correlation – The greater the default correlation, the greater the spread.

Page 54: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Use of Default Baskets

• Investors can leverage credit exposure and get a higher yield without increasing notional at risk.

• Reference credits are typically investment grade and require little extra analysis.

• Basket can be customized for the investors’ exact view regarding notional value, maturity, number of credits, credit selection, and the order of protection (FTD, STD, etc.)

Page 55: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Default baskets can be more cheaply used to hedge a portfolio of credits than hedging individually.

• Can be used to express a view on default correlation.

Page 56: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

Synthetic CDOs

• Similar to default basket

• Example:

• 100 CDS pool, $10 million notional value each. 3 tranches:– $50 million equity tranche, $100 million

mezzanine tranche, $850 million senior tranche

Page 57: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Spreads– Equity tranche: 1500bp– Mezzanine tranche: 200p– Senior tranche: 15bp

• A default in 1 of the 100 with a 30% recovery rate ($7 million loss).

Page 58: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

• Equity tranche loses $7 million of value.• Equity tranche notional value is now $43

million. The spread is now paid on this new value of $43 million.

• The process is repeated until $50 million losses are incurred. At that point the equity tranche is depleted and losses now accrue to the mezzanine tranche.

Page 59: Credit Derivatives 2003 – Notional value $2.31 trillion Investment grade bonds - $3.1 trillion

CDOs and beyond

• A CDS is a derivative.

• CDOs are a double derivative.

• There are triple derivatives. A CDO made up of CDOs.