Chapter 15 Credit Derivatives. Saunders & Allen Chapter 152 BIS Capital Requirements for Credit Derivatives Interest rate derivatives total $65 trillion

Chapter 15

Credit Derivatives

Saunders & Allen Chapter 15 2

BIS Capital Requirements for Credit Derivatives

• Interest rate derivatives total $65 trillion• FX derivatives exceed $16 trillion• Equity derivatives $2 trillion• As of 6/01: credit derivatives = $1 trillion.• Insurance cos. are net suppliers of credit risk

protection. Banks and securities firms are net buyers. Figure 15.1.

• BIS II proposes harmonization of treatment of credit derivatives. “w” factor adjusts risk weight.


70

60

50

40

30

20

10

0Banks Securities

FirmsCorporates

Protection PurchasedProtection Sold

InsuranceCompanies

HedgeFunds

Govt/ExportCredit

Agencies

MutualFunds

PensionFunds

Figure 15.1 Breakdown of CDS market participants.


Credit Spread Call Option

• Payoff increases as the credit spread (CS) on a benchmark bond increases above some exercise spread ST.

• Payoff on option = Modified duration x FV of option x (current CS – ST)

• Basis risk if CS on benchmark bond is not closely related to borrower’s nontraded credit risk.

• Figure 15.3 shows the payoff structure.


Payoff

Value of PutOptions onWheat

Payoff onLoan to Farmer

Borrower Assets

B0

Figure 15.2 Hedging the risk on a loan to a wheat farmer.


Payoff

Premium

Credit Spread

ST0

Figure 15.3 The payoff on a credit spread option.


Default Option

• Pays a stated amount in the event of default.

• Usually specifies physical delivery in the event of default.

• Figure 15.4 shows the payoff structure.

• Variation: “barrier” option – if CS fall below some amount, then the option ceases to exist. Lowers the option premium.


Premium

Par Valueof Loan

RepaymentPerformance

No DefaultDefault0

Figure 15.4 A default option.


Breakdown of Credit Derivatives: Rule (2001) British Bankers Assoc Survey

• 50% of notional value are credit swaps• 23% are Collateralized Loan Obligations (CLOs)• 8% are baskets (credit derivatives based on a small

portfolio of loans each listed individually. A first-to-default basket credit default swap is triggered by the default of any security in the portfolio).

• 6% are credit spread options


The Total Return Swap

• Swaps fixed loan payment plus the change in the market value of the loan for a variable rate interest payment (tied to LIBOR).

• Figure 15.5 shows the structure.• Table 15.1 shows the cash flows if the fixed loan

rate=12%, LIBOR=11%, and the loan depreciates 10% in value over the year (at swap maturity). Buyer of credit protection (the bank lender) receives 11% and pays out (12% - 10%) = 2% for a net cash inflow of 9%.


OtherFI(Counterparty)

BankLender

One Year LIBOR

Swap

F Loans to

ManufacturingFirm

(PT P0)P0

Figure 15.5 Cash flows on total return swap.


Credit Default Swaps (CDS)

• CDS specifies:– Identity of reference loan

– Definition of credit event (default, restructuring, etc.)

– Payoff upon credit event.

– Specification of physical or cash settlement.

• July 1999: master agreement for CDS by ISDA• Swap premium = CS• Figure 15.6 shows the cash flows on the CDS.


Seller ofCreditProtection

Buyer ofCreditProtection

(e.g. BankLender)

X Basis Points per Year

Credit EventPayment

ZeroNo Credit Event

Loans toCustomers

Figure 15.6 A credit default swap (CDS).


Pricing the CDS: Promoting Price Discovery in the Debt Market

• Premium on CDS = PD x LGD = CS on reference loan• Decomposition of risky debt prices to obtain PD (see

chapter 5):

• Basis in swap market (CDS premium CS) because:– Noise and embedded options in risky debt prices.– Liquidity premium in debt market.– Default risk premiums in CDS market for counterparty default

risk. Increase as correlations increase and credit ratings deteriorate. Table 15.2.

– High cost of arbitrage between CDS and debt markets.

PD = [1 – (1+RF)/(1+RF+CS)]/(LGD/100)


Table 15.2CDS Spreads for Different Counterparties

Correlation Between the

Counterparty & Reference Entity

AAA AA A BBB

0.0 194.4 194.4 194.4 194.4 0.2 191.6 190.7 189.3 186.6 0.4 188.1 186.2 182.7 176.7 0.6 184.2 180.8 174.5 163.5 0.8 181.3 176.0 164.7 145.2


Hedging Credit Risk with Credit Risk Forwards

• Credit forward hedges against an increase in default risk on a loan.• Benchmark bond CSF. MD=modified duration. • Actual CST on forward maturity date.

• Figure 15.8: Hedging loan default risk by selling a credit forward contract. Even if CSF > CST, then there is a maximum cash outflow since CST > 0

Figure 15.7 Payment Pattern on a Credit Forward Agreement Credit Spread at Credit Spread: Credit Spread: End of Forward Seller Buyer Agreement (Bank) (Counterparty) CST > CSF Receives Pays (CST – CSF) x MD x A (CST-CSF) x MD x A CSF > CST Pays Receives (CSF – CST) x MD x A (CSF – CST) x MD x A


PayoffGain

PayoffLoss

Payoff on Forward Contract

Maximum Valueof Loan

Maximum Losson Credit SpreadForward (CST 0)

Value of Loan/Payoff FromCredit Forwardat Maturity ofForward Contract

CST CSF 0 CST CSF 00

Figure 15.8 Hedging loan default risk by selling acredit forward contact.


Credit SecuritiizationsCLO, CLN, CDO

Since assets remain on the balance sheet, then there is no reduction in capital requirements, except under 1/2002 regulations for securities with recourse, direct credit substitutes, and residual interests supervised by US bank regulators. Sets risk weights from 20% (for AAA and AA rated) to 200% (for BB), but no change for unrated.

• High spreads in ABS market makes cost of financing high for banks.

• Might need borrowers’ consent to transfer loan to a SPV.• Reputational effects: ex. In July 2001, American Express

took a $1 billion charge because default rates on its CDOs were 8% rather than the expected 2%.


Synthetic SecuritizationBISTRO (Broad Index Secured Trust Offering)

• $10 billion loan portfolio backed by $850 million:

• Originating bank buys credit protection with a CDS that absorbs all credit losses after the threshold is met (eg., 1.5% so bank absorbs the first $150 million of losses).

• The BISTRO SPV is securitized with $700 million in US Treasury securities.

• So: holders of the BISTRO do not take credit losses unless the defaults exceed $850 million.

• Can use diversified portfolio (including loan commitments, letters of credit, and trade receivables) not eligible for inclusion in CLOs, CLNs or CDOs.


OriginatingBank

IntermediaryBank

Fee Fee

Senior &Subordinated

Notes

Contingentpayment on lossesexceeding 1.5% ofportfolio

Contingentpayment on lossesexceeding 1.5% ofportfolio

Credit Swap on$10 billion Portfolio

(Under BIS I market risk capital rules, the intermediary bank can use VAR to determine thecapital requirement of its residual risk position.)

Credit Swap on First $700Million of Losses

$700 millionUS Treasury

securities

$700 million

BISTROSPV

Capital MarketInvestors

Figure 15.9BISTRO structure.


Pricing a Credit Linked Note (CLN)

• $100 million 5 year coupon CLN guarantees payment of principal at maturity, but all coupon payments end if a default event occurs. Rf = 5% and CS = 7%

• PV of principal = $100/1.055 = $78.35 million. If selling at par, then PV of coupon payments = $100 – 78.35 = $21.65 million.

Table 15.3 Pricing a Credit-Linked Note Off The Spread Curve

Year Cumulative Probability of

Default

Expected Coupon Payment

Present Value of Coupons

1 7.22% (1-.0722)C .8837C 2 13.91 (1-.1391)C .7808C 3 20.13 (1-.2013)C .6900C 4 25.89 (1-.2589)C .6097C 5 31.24 (1-.3124)C .5388C

Notes: C is the fixed coupon payment on the CLN. The risk-free rate is assumed constant at 5 percent p.a. and the credit spread is fixed at 7 percent p.a. Source: Risk, (2000).


Appendix 15.1

• In this replication, the investor (swap risk seller):– Purchases a cash bond with a spread of T + Sc for par– Pays fixed on a swap (T + Sc) with the maturity of the cash bond and

receives LIBOR (L)– Finances the position in the repo market at a rate quoted at a spread to

LIBOR (L - x)– Pledges the bond as collateral and is charged a haircut by the repo

counterparty.

• First 2 transactions hedge the interest rate risk. The last 2 transactions reflect the cost of financing the purchase of the risky bond. Fig. 15.10

• The credit risk exposure of the swap seller = Sc – Ss + x which is the spread between the risky bond premium and the swap spread in the fixed-floating market plus the cost of setting up the arbitrage using repos.


CorporateAsset

Investor

Collateral

SwapMarket

CorporateSpread

RepoMarket

$100 T

SwapSpread

Repo Rate(L x)

L

$100*(1-Haircut)

T

Source: Credit Default Swaps, Merril Lynch, Pierce, Fenner,and Smith, Inc., October 1998, p. 12.

Figure 15.10 Replicate default swap exposure, protectionfor the swap seller.


Appendix 15.2BIS II Capital Regulations for ABS

• Assets can be removed from balance sheet only if there is a “clean break” such that the transferred assets are:– Legally separated from the bank, and– Placed into a SPV, and– Not under the direct or indirect control of the originating bank.

• If there is “implicit recourse” then the bank may not be able to remove assets from balance sheet.

• If the ABS has an early wind down provision, then the originating bank must apply a minimum 10% conversion factor.

• Banks investing in ABS have risk weights ranging from 20% (AAA and AA) to 50% (A+ to A-) to 100% (BBB+ to BBB-) to 150% (BB+ to BB-) to 1250% or a 1-for-1 capital charge if ABS is rated B+ and below


ABS Regulatory Arbitrage under BIS I and BIS II

• $100 million of BBB loans with capital charge of $8 million.

• Place loans into SPV and sell 2 tranches of ABS. – Tranche 1: $80 m rated AA since only absorb default losses up to 0.3%.

Sold to outside investors.

– Tranche 2: Residual $20m absorb all other credit losses – rated B. Retained by bank.

• Under BIS I, the bank’s capital requirement would be $20m x 8% = $1.6 m, a reduction of $6.4 million.

• Under BIS II, the capital charge on the $20 million tranche would be $20 million (1-for-1), thereby eliminating any arbitrage incentives.


$100mBBB

Loans

SPV

Tranche 1$80m of

Loans RatedAA

Investors

Tranche 2$20m of

Loans RatedB

Purchasedby Originating

Bank

Originating Bank

Figure 15.11 Regulatory arbitrage under BIS I.

Documents

Chapter 15 Credit Derivatives. Saunders & Allen Chapter 152 BIS Capital Requirements for Credit Derivatives Interest rate derivatives total $65 trillion