Understanding Credit Derivatives and Related Instruments

Antulio N. Bomfim

• Publisher: Academic Press
• Year: 2015
• ISBN:
  9780128004906
• Edition: 2
• Topic: Economía
• Subtopic: Bancos y banca

Understanding Credit Derivatives and Related Instruments, Second Edition is an intuitive, rigorous overview that links the practices of valuing and trading credit derivatives with academic theory. Rather than presenting highly technical explorations, the book offers summaries of major subjects and the principal perspectives associated with them.

The book's centerpiece is pricing and valuation issues, especially valuation tools and their uses in credit models. Five new chapters cover practices that have become commonplace as a result of the 2008 financial crisis, including standardized premiums and upfront payments. Analyses of regulatory responses to the crisis for the credit derivatives market (Basel III, Dodd-Frank, etc.) include all the necessary statistical and mathematical background for readers to easily follow the pricing topics.

Every reader familiar with mid-level mathematics who wants to understand the functioning of the derivatives markets (in both practical and academic contexts) can fully satisfy his or her interests with the comprehensive assessments in this book.

• Explores the role that credit derivatives played during the economic crisis, both as hedging instruments and as vehicles that potentially magnified losses for some investors
• Comprehensive overview of single-name and multi-name credit derivatives in terms of market specifications, pricing techniques, and regulatory treatment
• Updated edition uses current market statistics (market size, market participants, and uses of credit derivatives), covers the application of CDS technology to other asset classes (CMBX, ABX, etc.), and expands the treatment of individual instruments to cover index products, and more

Part I

Credit Derivatives: Definition, Market, Uses

Chapter 1

Credit Derivatives

A Brief Overview

Abstract

In this chapter, we discuss some basic concepts regarding credit derivatives. We start with a simple definition of what is a credit derivative and then introduce the main types of credit derivatives. Some key valuation principles are also highlighted.

Keywords

Single-name credit derivatives

Multiname-credit derivatives

Valuation principles

Static replication

Counterparty credit risk

Chapter Outline

1.1 What Are Credit Derivatives? 3

1.2 Potential “Gains from Trade” 4

1.3 Types of Credit Derivatives 5

1.3.1 Single-Name Instruments 5

1.3.2 Multiname Instruments 6

1.3.3 Credit-Linked Notes 7

1.3.4 Sovereign vs. Other Reference Entities 8

1.4 Valuation Principles 9

1.4.1 Fundamental Factors 9

1.4.2 Other Potential Risk Factors 10

1.4.3 Static Replication vs. Modeling 11

1.4.4 A Note on Supply, Demand, and Market Frictions 13

1.5 Counterparty Credit Risk (Again) 14

In this chapter, we discuss some basic concepts regarding credit derivatives. We start with a simple definition of what is a credit derivative and then introduce the main types of credit derivatives. Some key valuation principles are also highlighted.

1.1 What Are Credit Derivatives?

Most debt instruments, such as loans extended by banks or corporate bonds held by investors, can be thought of as baskets that could potentially involve several types of risk. For instance, a corporate note that promises to make periodic payments based on a fixed interest rate exposes its holders to interest rate risk. This is the risk that market interest rates will change during the term of the note. In particular, if market interest rates increase, the fixed rate written into the note makes it a less appealing investment in the new interest rate environment. Holders of that note are also exposed to credit risk, or the risk that the note issuer may default on its obligations. There are other types of risk associated with debt instruments, such as liquidity risk, or the risk that one may not be able to sell or buy a given instrument without adversely affecting its price, and prepayment risk, or the risk that investors may be repaid earlier than anticipated and be forced to forego future interest rate payments.

Naturally, market forces generally work so that lenders/investors are compensated for taking on all these risks, but it is also true that investors have varying degrees of tolerance for different types of risk. For example, a given bank may feel comfortable with the liquidity and interest rate risk associated with a fixed-rate loan made to XYZ Corp., a hypothetical corporation, especially if it is planning to hold on to the loan, but it may be nervous about the credit risk embedded in the loan. Alternatively, an investment firm might want some exposure to the credit risk associated with XYZ Corp., but it does not want to have to bother with the interest risk inherent in XYZ’s fixed-rate liabilities. Clearly, both the bank and the investor stand to gain from a relatively simple transaction that allows the bank to transfer at least some of the credit risk associated with XYZ Corp. to the investor. In the end, they would each be exposed to the types of risks that they feel comfortable with, without having to take on, in the process, unwanted risk exposures.

As simple as the above example is, it provides a powerful rationale for the existence of the expanding market for credit derivatives. Indeed, credit derivatives are financial contracts that allow the transfer of credit risk from one market participant to another, potentially facilitating greater efficiency in the pricing and distribution of credit risk among financial market participants. Let us carry on with the above example. Suppose the bank enters into a contract with the investment firm whereby it will make periodic payments to the firm in exchange for a lump sum payment in the event of default by XYZ Corp. during the term of the contract. As a result of entering into such a contract, the bank has effectively transferred at least a portion of the risk associated with default by XYZ Corp. to the investment firm. (The bank will be paid a lump sum if XYZ defaults.) In return, the investment company gets the desired exposure to XYZ credit risk, and the stream of payments that it will receive from the bank represents compensation for bearing such a risk.

The basic features of the financial contract just described are the main characteristics of one of the most prevalent types of credit derivatives, the credit default swap. In the parlance of the credit derivatives market, the bank in the above example is typically referred to as the buyer of protection, the investment firm is known as the protection seller, and XYZ Corp. is called the reference entity.¹

1.2 Potential “Gains from Trade”

The previous section illustrated one potential gain from trade associated with credit derivatives. In particular, credit derivatives are an important financial engineering tool that facilitates the unbundling of the various types of risk embedded, say, in a fixed-rate corporate bond. As a result, these derivatives help investors better align their actual and desired risk exposures. Other related potential benefits associated with credit derivatives include:²

• Increased credit market liquidity: Credit derivatives potentially give market participants the ability to trade risks that were previously virtually untradeable because of poor liquidity. For instance, a repo market for corporate bonds is, at best, illiquid even in the most advanced economies. Nonetheless, buying protection in a credit derivative contract essentially allows one to engineer financially a short position in a bond issued by the entity referenced in the contract. Another example regards the role of credit-linked notes, discussed in Chapter 12, which greatly facilitate the trading of bank loan risk.

• Potentially lower transaction costs: One credit derivative transaction can often stand in for two or more cash market transactions. For instance, rather than buying a fixed-rate corporate note and shorting a government note, one might obtain the desired credit spread exposure by selling protection in the credit derivatives market.³

• Addressing inefficiencies related to regulatory barriers: This topic is particularly relevant for banks. As will be discussed later in this book, banks have historically used credit derivatives to help bring their regulatory capital requirements closer in line with their economic capital.⁴

1.3 Types of Credit Derivatives

Credit derivatives come in many shapes and sizes, and there are many ways of grouping them into different categories. The discussion that follows focuses on three dimensions: single-name vs. multiname credit derivatives, funded vs. unfunded credit derivatives instruments, and contracts written on corporate reference entities vs. contracts written on sovereign reference entities.

1.3.1 Single-Name Instruments

Single-name credit derivatives are those that involve protection against default by a single reference entity, such as the simple contract outlined in Section 1.1. We shall analyze them in greater detail later in this book. In this chapter, we only briefly discuss the main characteristics of the most ubiquitous single-name instrument, the credit default swap (CDS).

In its most common or “vanilla” form, a CDS is a derivatives contract where the protection buyer agrees to make periodic payments (the swap “spread” or premium) over a predetermined number of years (the maturity of the CDS) to the protection seller in exchange for a payment in the event of default by the reference entity. CDS premiums tend to be paid quarterly, and the most common maturities are 3, 5, and 10 years, with the 5-year maturity being especially active. The premium is set as a percentage of the total amount of protection bought (the notional amount of the contract).

As an illustration, consider the case where the parties might agree that the CDS will have a notional amount of $100 million: If the annualized swap spread is 40 basis points, then the protection buyer will pay $100,000 every quarter to the protection seller. If no default event occurs during the life of the CDS, the protection seller simply pockets the premium payments. Should a default event occur, however, the protection seller becomes liable for the difference between the face value of the debt obligations issued by the reference entity and their recovery value. As a result, for a contract with a notional amount of $100,000, and assuming that the reference entities’ obligations are worth 20 cents on the dollar after default, the protection seller’s liability to the protection buyer in the event of default would be $80,000.⁵

Other examples of single-name credit derivatives include asset swaps, total return swaps, and spread and bond options, all of which are discussed in Part II of this book.

1.3.2 Multiname Instruments

Multiname credit derivatives are contracts that are contingent on default events in a pool of reference entities, such as those represented in a portfolio of bank loans. As such, multiname instruments allow investors and issuers to transfer some or all of the credit risk associated with a portfolio of defaultable securities, as opposed to dealing with each security in the portfolio separately.

A relatively simple example of a multiname credit derivative is the first-to-default basket swap. Consider an investor who holds a portfolio of debt instruments issued by various entities and who wants to buy some protection against default-related losses in her portfolio. The investor can obtain the desired protection by entering into a first-to-default basket with a credit derivatives dealer. In this case, the “basket” is composed of the individual reference entities represented in the investor’s portfolio. The investor agrees to make periodic payments to the dealer and, in return, the dealer promises to make a payment ...