Credit derivative
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A credit derivative is a contract (derivative) to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a credit reference asset. Early forms of credit derivative were financial guarantees. Some common forms of credit derivatives are credit default swap, total return swap and credit linked note.
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[edit] What are Credit Derivatives?
Credit derivatives are designed to allow independent trading/hedging of credit risk. It is also possible to transfer and/or transform credit risk through securitization.
The securitization process has become increasingly popular over the last decade, with structures ranging from the simple passing on of cash flows from underlying assets, to complex structures utilizing credit derivatives. We first discuss the principles of securitization in general to be able to understand the more complex products.
[edit] Types of Credit Derivative
Basically, three types of products can be distinguished, depending on the kind of risk transferred by the credit derivative:
- Total return swaps (TRS)
- Credit default swaps (CDS)
- Credit linked notes
- BSC Asse Swap
- Bespoke CSO
- Bespoke FTD
- Bespoke CDS Index
- Credit Default Swaption
- Recovery Lock
- Recovery Swap
- TRS Basket
- CDS Index
- CDS Index Option
- CDS Index Tranche
- CMCDS
- CDSABS
[edit] Trading Applications of Credit Default Swaps
[edit] Complex Structures
[edit] Securitization Concepts
Securitization is a group of techniques used for transforming illiquid sources of cash flow into tradable securities. Illiquid Sources of Cash Flow may include Home or Commercial Loans (Mortgage loans), Credit Card Accounts, Car Loans, Consumer Loans, Corporate Home Loans, Illiquid Bonds, Aircraft Leases, and many more asset and receivable types.
[edit] Credit Linked Notes and Obligations Collateralized Loans
There are several different types of securitized product, which have a credit dimension. Before looking at some of them in detail, let us look at some definitions to get the differences clear in our minds first. The market place often uses terminology interchangeably, but we might say that CLN is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
- Credit Linked Notes CLN: Credit Linked Note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
- Collateralized Debt Obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also exists CDO-squared (CDO^2) where the underlying assets are CDO tranches.
- Collateralized Bond Obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO
- Collateralized Loan Obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO
CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves!
[edit] Credit Linked Notes CLN
Numerous different types of CLNs have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.
Example: A bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs.
However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
[edit] Baskets
Simple baskets of instruments give investors exposure to a portfolio of risks and usually reduce risk through added diversification. A simple basket can comprise a portfolio of well diversified, high-yield or emerging-market instruments.
In contrast, first-to-default baskets are intended to increase risk and thereby increase returns for investors, who can lose their principal if any of the names in the basket defaults.
These more complex credit-linked structures have been available for some years, but they remain difficult to value and their risk is difficult to manage.
Nevertheless, they have proved to be attractive to specific investors looking for high returns.
[edit] Leverage
Leverage can be used as traditional financial leverage in order to increase the return on a given amount of funds invested. The increased return reflects the additional risk taken.
Leverage can also be used as duration leverage, where a CLN concentrates the risk of a longer-dated (for example, 10 years) instrument in a shorter-dated (for example, three years) instrument.
The principal amount of the note loses or gains value according to the mark-to-market of the long instrument when the note matures.
[edit] Credit Enhancements
By setting a subordinated tranche or subordinating one risk-taker's position to another, an issuer can create various cascading credit qualities within one single type of risk. Alternatively, by agreeing to unwind a trade if a trigger or covenant is hit, an issuer can improve or reduce the credit quality of the various parties in the transactions. Triggers or covenants are particularly useful for taking care of various contingent risks, such as the need to unwind an interest rate swap if the credit quality of the risk deteriorates dramatically. Our previous example had only one tranche, but as we saw in Section 1, there may be several tranches, each with a different risk structure.
- The Bank transfers risk in loan portfolio by entering into default swap with "ring-fenced" SPV
- The SPV buys gilts
- The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
- Tranche A absorbs the first 25% of losses on the portfolio
- Tranche B absorbs the next 25% of losses
- Tranche C the next 25%
- Tranche D the final 25%
- Tranches B, C and D are sold to outside investors
- Tranche A is bought by bank itself
[edit] Key concepts of the credit derivatives market
By setting a subordinated tranche or subordinating one risk-taker's position to another, an issuer can create various cascading credit qualities within one single type of risk. Alternatively, by agreeing to unwind a trade if a trigger or covenant is hit, an issuer can improve or reduce the credit quality of the various parties in the transactions. Triggers or covenants are particularly useful for taking care of various contingent risks, such as the need to unwind an interest rate swap if the credit quality of the risk deteriorates dramatically. Our previous example had only one tranche, but as we saw in Section 1, there may be several tranches, each with a different risk structure.
Main article: Tranche
Image:CreditLinkedNotesStructures.jpgthumb .
* The Bank transfers risk in loan portfolio by entering into default swap with "ring-fenced" SPV
* The SPV buys gilts
* The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
o Tranche A absorbs the first 25% of losses on the portfolio
o Tranche B absorbs the next 25% of losses
o Tranche C the next 25%
o Tranche D the final 25%
* Tranches B, C and D are sold to outside investors
* Tranche A is bought by bank itself
[edit] Credit default swap
- Main article: credit default swap
The credit default swap or CDS has become the main engine of the credit derivatives market, offering liquid price discovery and trading on which the rest of the market is based. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event happening in the reference entity. The contingent payment usually replicates the loss incurred by creditors of the reference entity in the event of its default. It covers only the credit risk embedded in the asset, risks arising from other factors such as interest rate movements remaining with the buyer.
[edit] Pricing
The calculation of an approximate price for a credit default swap requires the use of arbitrage arguments. Compare
- (a) the return achieved by one who pays $100 for a risky bond B maturing at time T, and
- (b) the return achieved by one who invests $100 at the risk-free interest rate, until time T, and simultaneously sells protection via a CDS on bond B.
Clearly both positions have a similar risk, which is that the issuer of bond B goes into default. In case (a) the investor gets only the recovery rate attached to B (the amount given a creditor of this type can recover on liquidation), in case (b) the seller of the CDS must purchase bond B for its face value, $100, which entails liquidating the risk free investment, and selling B at its recovery value. Arbitrage arguments suggests that similar risks should be compensated by a similar excess return. Thus the premium paid to the seller of the CDS should be approximately equal to the difference between the coupon of B, and the risk free rate.
To facilitate pricing, premium on a CDS is paid at a similar frequency to that in the swap and bond markets (typically quarterly).
The pricing method is approximate in that it ignores the credit risk of the CDS seller, who may be unable to buy the bond in the event of default (suppose in an extreme case that the seller is also the issuer of the bond which is protected).
[edit] Collateralized debt obligations (CDO)
- Main article: Collateralized debt obligation
Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche.
In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.
[edit] Total return swap
- Main article: total return swap
A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.
The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset.
The essential difference between a total return swap and a credit default swap (qv) is that the credit default swap provides protection against specific credit events. The total return swap protects against the loss of value irrespective of cause, whether default, widening of credit spreads or anything else...
[edit] Credit-linked note
- Main article: credit linked note
A note whose cash flow depends upon a credit event, which can be a default, credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note.
A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its regular-note features, a CLN is an on-balance-sheet asset, in contrast to a CDS.
Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults.
[edit] CDS swaption
This is an option on a credit default swap. A CDS option represents the right but not the obligation to buy or sell protection on an underlying reference credit at a specified strike spread at a specified date in the future. There are two types of options that can be bought or sold:
1. The right to buy credit protection (payer option)
2. The right to sell protection (receiver option)
CDS Options can also have a special feature called a knock-out clause. A knock out clause refers to a situation where following a credit event by the underlying credit occurs before the expiry date of the option and the CDS option knocks out.
[edit] Levels and flows
The Bank for International Settlements reported in December 2004 that notional amount on outstanding credit derivatives was $4.477 trillion with a gross market value of $131 billion (Regular OTC Derivatives Market Statistics).
[edit] See also
[edit] External links
- Finance IQ's Credit Derivatives 2007 Conference
- Comprehensive List of Web Credit Derivative Resources
[edit] Research
[edit] Articles
- History of Credit Derivatives, Financial-edu.com
- A collection of useful Creditflux Special Reports
- The Banker: Fools’ gold - 05 April, 2004
- A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International
- Why a Global Economic Deluge Looms - Gabriel Kolko
- Credit Derivatives:A primer
- Credit Derivative: a riskglossary
[edit] Software
- Credit trading and risk management systems
- Credit Derivative pricing models, and risk analysis
- Credit derivatives pricing and risk
- Fast Computation of the Expected Tranche Loss of CDO Credit Portfolio
- Pricing tools for users of Credit Derivatives products
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