Chapter 15
Credit Derivatives
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.
Saunders & Allen Chapter 15
2
Figure 15.1 Breakdow n of CDS market participants.
70
60
Protection Purchased
Protection Sold
50
40
30
20
10
0
Banks
Securities Corporates Insurance
Firms
Companies
Hedge
Funds
Govt/Export
Credit
Agencies
Saunders & Allen Chapter 15
Mutual
Funds
Pension
Funds
3
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.
Saunders & Allen Chapter 15
4
Figure 15.2 Hedging the risk on a loan to a w heat farmer.
Payoff on
Loan to Farmer
Payoff
Value of Put
Options on
Wheat
0
B
Borrow er Assets
Saunders & Allen Chapter 15
5
Figure 15.3 The payoff on a credit spread option.
Payoff
ST
0
Credit Spread
Premium
Saunders & Allen Chapter 15
6
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.
Saunders & Allen Chapter 15
7
Figure 15.4 A default option.
Par Value
of Loan
0
Default
No Default
Premium
Saunders & Allen Chapter 15
Repayment
Performance
8
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 firstto-default basket credit default swap is triggered
by the default of any security in the portfolio).
• 6% are credit spread options
Saunders & Allen Chapter 15
9
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%.
Saunders & Allen Chapter 15
10
Figure 15.5 Cash flow s on total return sw ap.
F
Other
FI
(Counterparty)
(PT  P0)
P0
Sw ap
Bank
Lender
Loans to
Manufacturing
Firm
One Year LIBOR
Saunders & Allen Chapter 15
11
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.
Saunders & Allen Chapter 15
12
Figure 15.6 A credit default sw ap (CDS).
X Basis Points per Year
Seller of
Credit
Protection
Buyer of
Credit
Protection
Payment
Credit Event
Loans to
Customers
(e.g. Bank
Lender)
No Credit Event
Zero
Saunders & Allen Chapter 15
13
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):
PD = [1 – (1+RF)/(1+RF+CS)]/(LGD/100)
• 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.
Saunders & Allen Chapter 15
14
Table 15.2
CDS Spreads for Different Counterparties
Correlation
Between the
Counterparty &
Reference Entity
AAA
AA
A
BBB
0.0
0.2
0.4
0.6
0.8
194.4
191.6
188.1
184.2
181.3
194.4
190.7
186.2
180.8
176.0
194.4
189.3
182.7
174.5
164.7
194.4
186.6
176.7
163.5
145.2
Saunders & Allen Chapter 15
15
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 15.7
Credit Spread at
End of Forward
Agreement
CST > CSF
CSF > CST
Payment Pattern on a Credit Forward Agreement
Credit Spread:
Seller
(Bank)
Receives
(CST – CSF) x MD x A
Pays
(CSF – CST) x MD x A
Credit Spread:
Buyer
(Counterparty)
Pays
(CST-CSF) x MD x A
Receives
(CSF – CST) x MD x A
• 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
Saunders & Allen Chapter 15
16
Figure 15.8 Hedging loan default risk by selling a
credit forw ard contact.
Payoff
Gain
Maximum Value
of Loan
0
CS T  CS F  0
CS T  CS F  0
Value of Loan/
Payoff From
Credit Forw ard
at Maturity of
Forw ard Contract
Maximum Loss
on Credit Spread
Forw ard (CS T  0)
Payoff on Forw ard Contract
Payoff
Loss
Saunders & Allen Chapter 15
17
Credit Securitiizations
CLO, 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%.
Saunders & Allen Chapter 15
18
Synthetic Securitization
BISTRO (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.
Saunders & Allen Chapter 15
19
Figure 15.9 BISTRO structure.
(Under BIS I market risk capital rules, the intermediary bank can use VAR to determine the
capital requirement of its residual risk position.)
Fee
Originating
Bank
Contingent
pay ment on losses
exceeding 1.5% of
portf olio
Credit Swap on
$10 billion Portf olio
Senior &
Subordinated
Notes
Fee
Intermediary
Bank
BISTRO
SPV
Capital Market
Inv estors
$700 million
Contingent
pay ment on losses $700 million
exceeding 1.5% of US Treasury
portf olio
securities
Credit Swap on First $700
Million of Losses
Saunders & Allen Chapter 15
20
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
1
2
3
4
5
Cumulative
Probability of
Default
7.22%
13.91
20.13
25.89
31.24
Expected
Coupon
Payment
(1-.0722)C
(1-.1391)C
(1-.2013)C
(1-.2589)C
(1-.3124)C
Present
Value of
Coupons
.8837C
.7808C
.6900C
.6097C
.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.
Saunders & Allen Chapter 15
Source: Risk, (2000).
21
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.
Saunders & Allen Chapter 15
22
Figure 15.10 Replicate default sw ap exposure, protection
for the sw ap seller.
Source:
Credit Def ault Swaps, Merril Ly nch, Pierce, Fenner,
and Smith, Inc., October 1998, p. 12.
Corporate
Asset
T  Corporate
Spread
$100
T
Sw ap
Spread
Investor
Sw ap
Market
L
Repo Rate
(L  x)
$100*(1-Haircut)
Collateral
Repo
Market
Saunders & Allen Chapter 15
23
Appendix 15.2
BIS 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
Saunders & Allen Chapter 15
24
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.
Saunders & Allen Chapter 15
25
Figure 15.11 Regulatory arbitrage under BIS I.
Originating Bank
$100m
BBB
Loans
Purchased
by Originating
Bank
SPV
Tranche 1
$80m of
Loans Rated
AA
Tranche 2
$20m of
Loans Rated
B
Investors
Saunders & Allen Chapter 15
26