Credit Derivatives Basics 1

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Sydney RPCLevel 14, 2 Park Street

Sydney NSW 2000 Australia

Credit Derivatives Basics:

An OverviewASPAC Capital Markets RPC


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Table Of Contents

Credit Derivatives Introduction

Credit Default Swaps

Total Return Swaps

Credit Linked Note/Deposits

Credit Spread Options

Portfolio and Hybrid Products

Key Legal Considerations

Appendix

Key Abbreviations


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Credit Derivatives

Definition & Characteristics:

It is a financial contract used to mitigate or assume specific forms ofcredit risks by hedgers or speculators

Ability to transfer risks relating to price of credit, without transfer of

underlying assets

Separation of credit risk from funding / liquidity risk Creation of array of unfunded credit products

Leading to

increased credit risk trading opportunities

increased investor access to credit products


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Credit Default Swaps (CDS)

Definition:

CDS are credit derivatives in which Protection buyer pays periodic feeto Protection seller and Seller covers Buyer against default

On occurrence of predefined credit event in relation to reference entity,

seller pays a contingent amount to buyer

CDS transfers the potential loss on an reference asset that can resultfrom specified credit events such as bankruptcy, default etc

Factors affecting the Fees (Pricing):

Asset swap price of reference asset

Repo cost of reference asset

Counterparty risk

Correlation


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CDS Payoffs

No credit event before maturity:

Protection

Seller

X bps p.a. on NotionalAmount

Protection

Buyer


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CDS Payoffs (Contd.)

Credit event before maturity (contd.):

Option 1 Physical Delivery:

Option 2 Cash Settlement:

Protection

Seller

Protection

Buyer

Settlement Amount

Settlement Amount = Notional Principal x (Par - Recovery Value)%

Protection

Seller

Protection

Buyer

Notional Amount

Deliverable Obligations of

the Reference Entity


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CDS Payoffs (Contd.)

Physical Delivery Vs Cash Settlement:

Contingent Payments most often are computed in one of two ways

Net cash settlement (100% - Recovery Value of reference asset),determined by dealer-poll of Reference Entity

Physical delivery of defaulted obligations of the reference entity to Seller

Choice of Cash or Physical settlement influenced by:

Illegality and Impossibility of Physical Delivery

View on the potential price of relevant assets of the defaulted entity after acertain time period

Liquidity of the underlying security Protection buyer may have access to Cheapest-to-Deliver bond


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CDS Key Features

Key Features:

Reference Entity can be a single credit (sovereign or corporate) or thefirst-to-default in a basket of credits

Buyer either delivers defaulted obligations of the reference entity to

Seller or net cash settlement of the market value

Buyer decreases exposure to Reference Entity, but assumes contingentexposure to Seller. Correlation between credit of Reference Entity and

Seller will affect premium.

Provide a means to hedge illiquid credit exposures on an anonymous

basis and allow transfer of credit risk without transfer of ownership

May be more flexible and efficient than traditional credit risk

management tools collateral, shorting securities, reinsurance,

guarantees


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CDS Applications

Buyer Applications:

Synthetically short security

Hedge credit on held asset

Diversify concentrated portfolio

Seller Applications:

Unfunded position; create leverage

Higher return than cash instruments

Generate income on unutilized credit lines

Off balance sheet credit exposure

Diversify concentrated portfolio


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Total Return Swaps (TRS)

Definition:

TRS transfer the returns and risks on an underlying reference assetfrom one party to another

The buyer pays a periodic fee to seller and receives total economic

performance of underlying reference asset in return

Total Returns include interest payments + amount based on change in

assets market value

So if price goes up, buyer gets and amount = appreciation in value

If price goes down, buyer pays an amount = decline in value


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TRS Payoffs

Payoff:

Receiver earns coupons + periodic positive MTMs on reference asset

Receiver pays Libor + Margin + periodic negative MTMs on reference

asset

Transfers total performance without transfer of asset

Captures spread movement and default

Unfunded equivalent of funded asset purchase

Receiver Payer

Total positive returns

on Ford Bond

LIBOR + Margin

+ Losses on Reference BondSynthetic long

bond position

Synthetic short

bond position


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TRS Features

Applications:

Self-financing; create leverage

Lock in funding rate

Access to new markets/securities with no repo market

Pricing:

Margin depends upon:

Cost of funds and capital

Repo cost of reference asset

Counterparty risk Correlation


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Credit Linked Note/Deposits (CLN/ CLD)

Definition & Key Features:

These are securities that effectively embed default swaps within atraditional fixed income structure. They typically pay periodic interest

plus, at maturity, the principal minus a contingent payment on the

embedded default swap

CLN/CLD are, unlike CDS, funded instruments which allows the creditprotection buyer to avoid the contingent credit exposure to the

protection seller.

Designed to resemble a synthetic bond or loan and offers investors

tailored credit exposure.

The CLN/CLD is payable in full at maturity unless a Credit Event

affecting the Reference Entity occurs during the instruments life. The

coupon of the CLN/interest on CLD reflects the issuers funding cost

plus an amount to compensate for the credit risk of the Reference Entity


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CLN/ CLD (Contd.)


If the Reference Entity suffers a Credit Event, the investor receiveseither physical bonds or a cash amount equivalent to the post-default

market value of the physical bonds. The note/deposit is then terminated

The default contingency is very flexible and may be linked to various

underlying assets (loans, securities) The amount of exposure/risk taken can also be structured so as to

provide full or partial protections of principal


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CLN/ CLD Payoff

On Trade date:

Assume Principal amount = $ 10 MM

USD 10 mio

Note Issuer Investor


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CLN/ CLD Payoff (Contd.)

No Credit Event before Maturity:

Credit Event before Maturity:


USD 10 MM + Interest * USD 10MM at Maturity

USD 10 MM equivalent of DeliverableObligations of the Reference Entity

No payments after Credit Event

InvestorNote Issuer


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CLN/ CLD Applications

For Investors:

CLNs offer cash-based investors access to:

New credit risks

Credit risk in new currencies

Credit risk for unavailable maturities

CLNs provide yield leverage (more than one name exposure)

CLNs provide the portfolio effects of diversification

However, these are complex to execute and have less liquidity vs.

Eurobonds)


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CLN/ CLD Applications (Contd.)

For Issuers:

CLNs provide an effective mechanism to transfer credit risk

For hedging

Shorting credit risk (spread)

Primary markets; credit arbitrage-driven financing

Diversification of the investor base

Alternative to ABS

Simpler; no asset-holding issuer vehicle

Assets not transferred; relationship impact


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Option seller gives right to buyer to buy/sell asset at agreed spread over Libor

E.g., A put option on credit spreads gives the buyer the right but not the

obligation to sell the underlying asset/purchase credit default protection at a

certain pre-specified credit spread

This effectively gives the buyer of a credit spread put option protection againstcredit spreads widening at a future date

Spread is usually calculated as yield differential between reference bond and

interest rate swap of same maturity

Unlike CDS or TRS, counterparties DO NOT have to define a specific credit

event payoff happens regardless of reasons for credit spread movement


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Credit Spread Options Payoff

E.g.:

Bank C owns asset XYZ at L+20 bp but needs credit line

Bank D will buy asset at L+25 bp

Bank C buys 1 year put struck at L+25 bp for 10 bps

Bank C replaces XYZ risk with Bank D risk

Bank D takes contingent credit risk on XYZ


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Credit Spread Options Payoff

E.g.:

Bank C Bank D

XYZ

bond

if spread > 25 bp

if spread < 25 bp

premium 10 bp

sells asset at L + 25 bp

option lapses

L + 20 bp


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Portfolio Products

FIRST-TO-DEFAULT BASKETS:

A credit default swap in which swap returns are linked to first default in abasket of issuer.

The exposure to each name is for full notional of the protection and principal

and interest are at risk only to the Reference Entity being the first to default.

Namely, if one of the Reference Entity in the First-to-Default Basket suffers aCredit Event, the protection seller receives either physical bond of the defaulted

Reference Entity or a cash amount equivalent to their post-Default market

value. The transaction is then cancelled.

Cheaper than buying single name default swaps for each name in the basket Buying 2nd and 3rd etc. to default increases extent of credit protection

Spread of worst credit < basket swap spread < Sum of spreads of individual

credits


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Portfolio Products (Contd.)

FIRST-TO-DEFAULT CLN EXAMPLE:

Principal Amount: USD 10 mio

Maturity: 5 years

Interest: Libor + 270 bps p.a. (semi-annually)

Reference Basket:

Reference 1

Reference 2

Reference 3

At Trade date:

USD 10 mioNote Issuer Investor


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Portfolio Products (Contd.)

FIRST-TO-DEFAULT CLN EXAMPLE:

No Credit Event Before Maturity:

First Credit Event among Reference 1,2 and 3 Before Maturity:

Investor

Note Issuer

USD 10 mio + Interest * USD 10 mio at

Maturity

Investor

USD 10 mio equivalent of Deliverable Obligations of

the Defaulted Reference Entity

No payments after Credit Event



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Hybrid Products

Quanto Credit Default Swaps:

A structured credit default swap where the notional is denominated in a non-standard (non-G7) currency

This allows protection buyers to avoid currency mismatches between the

bought credit protection and their underlying exposures

Credit Contingent Swaps (Disappearing/Extinguishing Swaps):

A swap that will be terminated with zero termination value upon the occurrence

of a credit event on the swap counterparty and/or a third-party reference credit.

The risks will be dynamically managed using a combination of credit products

as well the various market-risk factors (that determines the mark-to-market

value of the swap)

Key considerations:Right-way exposure and correlation


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations


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Key Legal Aspects

Documentation:

ISDA Master Agreement

Confirmation

Conditions of Payment:

Define Credit Event (Default)

Bankruptcy

Cross Acceleration / Cross Default

Failure to pay (on what / how much?)

Restructuring Repudiation

Credit Spreads widening etc

Publicly Available Information like Reuters / Telerate etc


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Table Of Contents



Total Return Swaps





Appendix

Key Abbreviations

A di Abb i ti U d


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Appendix Abbreviations Used

MTM: Mark to Market

CDS: Credit Default Swap

BP: Basis Point

TRS: Total Return Swap

CLN: Credit Linked Note

CLD: Credit Linked Deposit

Mio: Million

MM: Million

Documents

Credit Derivatives Basics 1