Final Credit Derivatives

8/6/2019 Final Credit Derivatives

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Credit Derivatives

Avinash Deshmane

Sachin Ghume

Nikunj Parekh

Mukesh


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Credit Derivatives

Credit Derivatives

Credit derivatives are over-the-counter bi-lateralagreements designed explicitly to shift credit risk

between the parties; its value is derived from the credit

performance of one or more corporation, sovereignentity, or security.

Credit derivatives arose in response to demand byfinancial institutions, mainly banks, for a means ofhedging and diversifying credit risks similar to those

already used for interest rate and currency risks.

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Credit Derivatives

Types of Credit Derivatives

Credit Default Swap

Total Rate of Return Swaps

Credit Spread Option

Credit Linked Note

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Credit Derivatives

Credit Default Swap

Credit default swaps allow one party to "buy"protection from another party for losses that might be

incurred as a result of default by a specified reference

credit (or credits).

The "buyer" of protection pays a premium for theprotection, and the "seller" of protection agrees to make

a payment to compensate the buyer for losses incurredupon the occurrence of any one of several specified

"credit events."

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Credit Derivatives

Credit Default Swap

Example:

Suppose Bank A buys a bond which issued by a SteelCompany.

To hedge the default of Steel Company:

Bank A buys a credit default swap from Insurance

Company C.

Bank A pays a fixed periodic payments to C, inexchange for default protection.

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Credit Derivatives

Credit Default Structure

Bank (A) pays a premium (single or periodic payments) to

a Insurance Company (B), but if a credit event occurs the

seller (B) will compensate the buyer.

DefaultProtection

BUYER (A)

Default

Protection

SELLER (B)

Reference

Entity

Contingent Payment if a

Credit Event Occurs

Fixed Payments / Premium

Credit

Exposureto Reference

Entity

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Credit Derivatives

Settlement Following a Credit Event Physical Settlement:

Protection BUYER delivers eligible debt (typically a bond orloan) to the Protection SELLER in exchange for a cash

payment equal to par

Cash Settlement: Calculation Agent makes a market value determination of loss

(par minus recovery) that the Protection SELLER is then

obligated to pay to the BUYER

Lump-sum

Fixed payment if a trigger event occurs

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Credit Derivatives

Example

T

he protection buyer (A) enters a 1-year creditdefault swap on a notional of $100M worth of 10-year

bond issued by XYZ. Annual payment is 500 bp.

At the beginning of the year A pays $500,000 to theseller.

Assume there is a default of XYZ bond by the end

of the year. Now the bond is traded at 40 cents on

dollar.

The protection seller will compensate A by $60M.

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Credit Derivatives

CDS Applications Delphi

Corporation Case Study

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Credit Derivatives

CDS Applications - DPH Trade

Solution Details

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Credit Derivatives

CDS Applications Delphi

Bankruptcy

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Credit Derivatives

Total Return Swap

Total return swaps are contracts between two

counterparties, under which the total economic risk of

ownership of a designated asset or set of assets is

transferred from one counterparty to the other. By the totaleconomic risk, we mean not just the credit risk of a

particular asset, but also the interest rate risk, and any other

more complex risks that may also impact the value of the

designated asset or set of assets.

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Credit Derivatives

The easiest way to understand how a total return swap works is by considering an

example:

Total Return Receiver : Counterparty A

Total Return Payer: Counterparty B

Start Date:10 December 1999

End Date:10 December 2004

Term:5 Years

Reference Asset XYZ Corporation Bonds

( 8% Coupon, Maturing 22 November 2019)

Initial Price of Reference Asset 102%Final Price of Reference Asset The price of the Reference Asset two business

days before the End Date

Nominal Amount: $10,000,000

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Credit Derivatives

Amount: Nominal Amount x Initial Price of Reference Asset

6 Month LIBOR + Floating Rate Margin, calculated on the

Notional Principal Amount,

Payable semi-annually for the term of the contract.

0.15%

Semi-annually in arrears, starting six months after the Start

Date.

The Total Return Receiver pays the Floating Rate Payment

to the Total Return Payer on each Floating Rate Payment

Date, until ( and including ) the End Date.

All coupons and other fees and cash sums payable to holders

of the Reference Asset.

Two business days after the Total Return Payments are

Received by theT

otal Return Payer from the Paying Agentof the Reference Asset.

The Total Return Payer pays the Total Return Payments to

the Total Return Receiver on the Total Return Payment

Dates.

Notional Principal

Floating Rate Payments:

Floating Rate Margin:

Floating Rate Payment Dates:

Floating Rate Payments:

Total Return Payments:

Total Return Payment Dates:

Total Return Payments:

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Credit Derivatives

EXAMPLE BASED ON ABOVE TERMS

To understand how this transaction works, imagine that Counterparty B, the TotalReturn Payer, has bought $10,000,000 nominal of the XYZ Corporation 8% bonds of

2019 in December 1999. What are the Counterparty B's cash flows, if he then also

enters into this total return swap?

From the bond, Counterparty B will receive coupons, so long as XYZ Corporation

doesn't default. Under the terms of the total return swap, however, Counterparty B

will not keep these payments, but will immediately pay them to Counterparty A asTotal Return Payments. In return, Counterparty A will pay the Floating Rate

Payments to Counterparty B; these are LIBOR plus a spread, calculated on the

amount that Counterparty B has invested in the XYZ Corporation bonds. So, overall,

Counterparty B is receiving a sequence of floating rate payments

( LIBOR + 0.85% ), and that's it, at least until 2004.

That is, Counterparty B has created the same effect as entering into an asset swap.The interesting thing is what happens when the total return swap ends: if the price of

the underlying bonds has increased over the term of the swap, Counterparty B pays

the profit to Counterparty A; if the bonds have fallen in price, however, Counterparty

A will compensate Counterparty B for the losses that B would otherwise incur.

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Credit Derivatives

Credit Spread Option

In finance, a credit spread, or net credit spread,

involves a purchase of one option and a sale of

another option in the same class and expiration but

different strike prices. Investors receive a netcredit for entering the position, and want the

spreads to narrow or expire for profit. In contrast,

an investor would have to pay to enter a debit

spread.

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Credit Derivatives

Consider the following scenarios:

The stock falls or remains BELOW $36 by expiration. In this case all the options expire worthless and the

trader keeps the net credit of $350 minus commissions (probably about $20 on this transaction)netting approx $330 profit.

If the stock rises above $37 by expiration, you must unwind the position by buying the 36 calls BACK,

and selling the 37 calls you bought; this difference will be $1, the difference in strike prices. For all

ten calls this costs you $1000; when you subtract the $350 credit, this gives you a MAXIMUM Loss

of $650.

If the final price was between 36 and 37 your losses would be less or your gains would be less. The

"breakeven" stock price would be $36.35: the lower strike price plus the credit for the money you

received up front.

Traders often using charting software and technical analysis to find stocks that are OVERBOUGHT (have

run up in price and are likely to sell off a bit, or stagnate) as candidates for bearish call spreads.

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Credit Derivatives

If the trader is BULLISH, you set up a bullish credit spread using puts. Look at the

following example.

Trader Joe expects XYZ to rally sharply from its current price of $20 a share.

Write 10 January 19 puts at $0.75 $750

Buy 10 January 18 puts at $.40 ($400)

net credit $350

Consider the following scenarios:

If the stock price stays the same or rises sharply, both puts expire worthless and you keep

your $350, minus commissions of about $20 or so.

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Credit Derivatives

If the stock price instead, falls to below 18 say, to $15, you must unwind the

position by buying back the $19 puts at $4 and selling back the 18 puts at $3

for a $1 difference, costing you $1000. Minus the $350 credit, your maximumloss is $650.

A final stock price between $18 and $19 would provide you with a smaller loss or

smaller gain; the breakeven stock price is $18.65, which is the higher strike

price minus the credit.

Traders often scan price charts and use technical analysis to find stocks that are

OVERSOLD (have fallen sharply in price and perhaps due for a rebound) as

candidates for bullish put spreads.

NOTICE IN BOTH cases the losses and gains are strictly limited. This is a nice

strategy for earning a modest amount of income from a portfolio that can be

used to supplement your wages, dividends, or social security payments as long

as you're aware of the limits

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Credit Derivatives

Credit Linked Notes (CLN)

CLNs are generally created through a Special Purpose Vehicle(SPV), or trust, which is collateralized with highly rated

securities. CLNs can also be issued directly by a bank or

financial institution.

A CLN is normally a bond that has been issued using a mediumterm note programme.

It is the direct obligation of the issuer but it contains additional

credit risks for the buyer.

The principal repayment is linked, not only to creditworthiness ofthe issuer but also a third party known as the reference entity.

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Credit Derivatives

Credit Linked Notes (CLN)

Provided the reference entity experiences no credit event during thelife of the CLN the principal will be repaid to the investor on

maturity.

During the life of the note the investor will also have received

regular interest payments (coupons).If the referenced entity defaults or declares bankruptcy, in which

case, instead of receiving the principal amount originally

invested, the investor receives a bond issued by the reference

entity. The investor will have experienced a loss as a result of the

credit event because the delivered bond will be worth less than

the original sum invested. The scale of the loss incurred will

depend on the market value of the delivered bond

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Credit Derivatives

Example

Start with the CLN issuer or Bank,

who owns a bond. Instead of

shouldering the risk of the bond,

Bank issues a note to the CLN

buyer. The note has an embedded

credit feature. It pays a highercoupon unless the bond is

downgraded or defaults. If the bond

is downgraded, the coupon paid by

the CLN issuer to the CLN buyer is

reduced. If the bond defaults, theCLN issuer diverts recovery (i.e.,

par value minus expected recovery

rate) to the CLN buyer.

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Credit Derivatives

Synthetic CLN

In this case, the CLN issuer or Bank does not

own the bond (the risky asset). Instead, the CLNissuer achieves synthetic exposure to the bond by

selling a credit default swap (CDS) to the bond's

actual owner. Selling protection would mean the

Issuer received a regular fixed payment from the

CDS counterparty.

The bank now issues the CLN. The CLN would

be for the same principal amount and maturity as

the CDS. The Bank sells a note to the CLN

buyer, but the proceeds are invested in a riskless

asset. The CLN buyer would pay cash to the CLN

Issuer to buy the note. The Issuer would pay the

buyer regular interest (coupons) until thematurity of the note.

Provided there is no credit event by the reference

entity the buyer receives back the principal

investment on the maturity of the note.

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Credit Derivatives

Synthetic CLN

If there is a credit event, The CDS on which the

Issuer sold protection is triggered. The bank paysto the CDS counterparty the principal amount of

the CDS in cash. The bank receives in return a

deliverable instrument normally a bond that was

issued by the reference entity that is now in

default.

The CLN is also triggered. The investor does not

get his principal returned, instead the bank on-

delivers the bond to the CLN buyer. The investor

will have experienced a loss as a result of the

credit event because the delivered bond will be

worth less than the original sum invested. The

scale of the loss incurred will depend on themarket value of the delivered bond.

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Credit Derivatives

Thank You

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Documents

Final Credit Derivatives