drake drake university fin 288 credit derivatives finance 288 futures options and swaps

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Fin 288

Credit Derivatives

Finance 288Futures Options and Swaps

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Fin 288Credit Risk

Default RiskThe risk that the debtor or counterparty will default on its obligation.

Migration / Deterioration RiskThe risk that there will be decline in the credit quality of the of the debtor or counter party.


Fin 288Credit Default Swap

The buyer makes an upfront payment or a stream of payments to the seller of the swap.The seller agrees to make a stream of payments in the event of default by a third party on a reference obligation.


Fin 288Basic Credit Default Swap

Default Swap Buyer

DefaultSwapSeller

Reference

Obligation Issuer

Upfront Payment orStream of payments

Payment in the Event of Default

Return on

Reference

Obligation

OriginalPayment


Fin 288

Credit Default Swap as an Option

The Credit Default Swap is basically a put option on the reference obligation.The default buyer owns the put option which effectively allows the reference obligation to be sold to the CDS seller in event of default.


Fin 288Intuition

Assume that the reference obligation is a bondIf the price of a bond decreases due to a change in credit quality, the value of the put option increases. This implies that the value of the CDS increases.The CDS buyer could sell the obligation at a premium compared to what was paid originally.


Fin 288What Constitutes Default

The CDS parties can agree to any or all of the events below

BankruptcyFailure to PayObligation AccelerationObligation DefaultRepudiation or deferralRestructuring


Fin 288

What Does not Constitute Default

Downgrade by rating agencyNon Material events (error by employee causing a missed payment etc.)


Fin 288Hedge against Default

In the event of a default the swap buyer is hedged against the risk of default.The CDS is effectively an insurance policy against default.The risk of default is transferred to the seller of the CDS.


Fin 288

Hedge against credit deterioration?

Since rating agency changes do not constitute default how are credit changes hedgedIf the CDS is marketed to market then the change in value serves as a hedge against changes in credit quality


Fin 288An Example

Assume that the CDS buyer owns an 7% coupon bond and the return on a similar maturity treasury is 5%.Assume that both bonds have a current value of $1 Million (equal to their par value)Assume the buyer pays 2% per year for the duration of the swap and receives $1 Million in the even of default.The combination of the CDS and 8% bond have effectively the same payoff as the treasury


Fin 288Credit Default Swap

Default Swap Buyer

DefaultSwapSeller

Reference

Obligation Issuer

2% per year

$1 Million in the Event of Default

7% per year

$1 Million


Fin 288Risks in the CDS

The CDS seller may defaultWe assumed that the spread between the two bonds stays constant over time and that the duration and convexity of the bonds stays the same. (unlikely especially for a bond closeto default)We have ignored accrued interest There could be a liquidity premium for the risky bond causing it to sell for less than its true value.


Fin 288Other CDS variations

Binary or Digital Default Swap – Payoff is a single lump sum often based upon recovery rates.Basket CDS - the reference obligation is a basket of obligations

N to default – default exists when the Nth obligatin defaults First to default

Cancelable DS –either the buyer (call) or seller (put) has the right to cancel the default swap


Fin 288CDS Variations continued

Contingent CDS – triggered if both the default and a second event occurLeveraged CDS – Payoff is a multiple of the loss amount often the standard CDS amount plus a % of the notional valueTranched Portfolio Swaps – A variation of CDOs


Fin 288Benefits of CDS

The risk is transferred to a financial institution that often has better ability to hedge the risk than the swap buyer.Allows lenders to hedge the risk of high risk loans without jeopardizing the lender – client relationshipReduction of regulatory capital.


Fin 288A costless reduction in risk

Assume that Bank A has sold a CDS to Co X on a 100,000,000 notional amount and is receiving a 3% semi annual interest rateSimilarly Bank B has the same agreement with Co Y.Assuming both company’s have the same credit qualityBy exchanging a portion of the notional value of the swap the banks can diversify the credit risk without any costs.


Fin 288

Credit Default SwapRisk Sharing

Bank

A

Company

X

$50 M of CDSWith Co X

$50 M of CDSWith Co Y

Company

Y

3% on $100M

Bank

B

Payment If Default

Payment If Default

3% on $100M


Fin 288An arbitrage example

Assume that a foreign country is undergoing a financial crisis and bonds based in the country are trading at a high yield of 18%However the CDS premium on the foreign bond is 11%Currently the treasury yield is 5%By shorting the treasury and using the proceeds to buy the foreign bond, the firm can lock in a profit.


Fin 288

Credit Default SwapArbitrage

Arbitrageur

Treas Bond

Buyer

Cash

18% Yield

Company

Y

11% Premium

Foreign bond Seller

Payment If Default

Treas Yield 5%

Cash


Fin 288

Adjusting Regulatory CapitalA Banking Example

Basel II Accords have specified how risk based capital should be calculated based upon a weighted riskiness of an asset.


Fin 288New Basel Accord (Basel II)

Basel Agreement – imposes risk based capital requirements on banks in major industrialized countriesPillar 1: Credit, market, and operational risksCredit risk:

Standardized approachInternal Rating Based (IRB)

Market Risk --Unchanged


Fin 288Basel II continued

Operational:Basic IndicatorStandardizedAdvanced Measurement Approaches


Fin 288Basel II continued

Pillar 2Specifies importance of regulatory review

Pillar 3Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks


Fin 288Capital

Divided into Tier I and Tier IITier I – closely linked to book value, represents the core contributions to banks owners. Includes common stockholders equity, some preferred stock, equity interests of subsidiaries Tier II – secondary capital. Includes loan and lease losses, hybrid capital (perpetual debt), subordinated debt, revaluation reserves


Fin 288Risk-based Capital Ratios

Basle I AgreementEnforced alongside traditional leverage ratioMinimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio.Also requires, Tier I (core) capital ratio

= Core capital (Tier I) / Risk-adjusted 4%.Crudely mark to market on- and off-balance sheet positions.


Fin 288Calculating Risk-based

Capital Ratios

Tier I includes:book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill.

Tier II includes:loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps


Fin 288Calculating Risk-based

Capital Ratios

The risk based capital ratio is based upon the risk weight. The minimum amount to be in capital is 8% multiplied by the risk weight and the notional value of the loan.For example if you made a loan to an A rated corporation it would have a risk weight of 50%.On a $100M loan the required capital would be$100M(.5)(.08) = $4 Million


Fin 288CDS and risk based capital

The original risk weight for the buyer of the credit derivative was defined asr*=wr+(1-w)g

where w = .15 for all credit derivatives giving protection

r = risk weight of the obligor g = risk weight of the protection

seller


Fin 288An example

Assume that you have made a $1,000,000 loan to a corporation with an A rated corporation as before. However now you offset it with a CDS sold by a AAA rated bank with a risk weight of 20%.r* = .15(.50)+(1-.15).20 = .245This implies a capital requirement of.245(1,000,000)(.08) = $19,600 as opposed to.50(1,000,000)(.08) = $40,000


Fin 288Weights

The 15% weight for the CDS is designed to cover operational risks that might make enforcement of the CDS difficult.The 15% has received much critisisim and a counter proposal would allow the risk weight to be set equal to the credit quality of the seller of the CDS. This could increase, or decrease the new risk weight depending upon the ratings of the original borrower and the CDS seller


Fin 288CDOs

drake drake university fin 288 credit derivatives finance 288 futures options and swaps

Documents

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default buyer

risk of default

default downgrade

credit risk default

event of default return

cds buyer

credit quality slide