Credit Play Checkmate
Jamila
Awad
Credit Play Checkmate:
Trading Credit Risk Financial Instruments
Author
Jamila Awad
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JAW Group
Date
June 2013
Paper: “Credit Play Checkmate” (2013)
Author: Jamila Awad
Date: June, 2013
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Credit Play Checkmate
Jamila
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Executive Summary
The globalization of financial markets and the automation of monetary transactions
accentuated the desideratum to manage sophisticated economic instruments such as credit
play products. The delivered disquisition aspires to illuminate the comprehension of
market participants in sage credit risk derivative trading and thus prevent perilous
financial checkmate. The dissertation is partitioned in three sections. The inaugurating
section cements the regulatory and environmental foundations to embrace credit play
instruments. The following sections decapsulate the retained debt derivatives in two
distinct categories: simple-forms and multi-structures. In brief, the sound implementation
of credit risk derivative financial engineering innovation shall no longer be perceived as a
threat to the economic system.
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Credit Play Checkmate
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Introduction
Credit derivative instruments intend to successfully transfer and redistribute credit risk.
Dynamic hedging with credit derivatives targets to retrench risk concentrations on
balance sheets as well as to liberate capital for regulatory purposes. Precisely, these
sophisticated financial tools partition a group of assets directed to dilute the panoply of
risks induced and offer new investment opportunities to a clientele with tailored risk
appetites. Financial institutions can therefore decrease chambered economic capital
ordered by authority regulations with sound credit derivative hedging.
The redaction strives to educate the financial community about a prudent and efficient
implementation of credit play instruments and thus safeguard the economic system from
meltdowns and armor common-man confidence. Financial institutions engaged in trading
activities are ordered to chamber regulatory capital to buffer unanticipated losses in their
banking and trading books. Credit derivative products shall therefore be adequately
processed to mitigate credit risk and contribute in relieving dormant economic capital.
The Basel banking guidelines as well as the Dodd-Frank-Volcker reform address the
restrictions of credit play products and the enforcement of trading boundaries. In
addition, international accounting bodies continuously modernize standards destined to
guide entities in the financial playfield on the concept of fair value hedging.
The International Swaps and Derivatives Association represents the organization
responsible for the superintendence and coercion of credit derivative trading. The
imminent Dodd-Frank-Volcker American regulatory ordinance will shift traditional
proprietary players towards the alternative investment field. In addition, the use of credit
derivative holds a history in the securitization process whereas debt financial tools
diminish credit risk concentrations and securitize loan portfolios.
Purchasing a credit derivative is equivalent to shorting a credit risk and selling a credit
derivative corresponds to vending a credit protection. Credit play instruments target the
following financial obligation domains: bonds, loans, borrowed cash and lastly payments.
The LIBOR or the Euribor swap curve depicts the interest rate benchmark at which
financial entities hedge credit risks. The credit derivative market is accessible to a wide
range of investors due to repacking vehicles who create securities to grasp a clientele.
The examination of portfolio trading requisites to evaluate the following parameters: the
number of assets in the portfolio, the default probabilities, the recovery rates, and finally,
the default correlations between the assets contained in the portfolio. In addition, the
default characteristics augment for large portfolios that necessitate a sophisticated
valuation model.
The credit derivative market breadth impacts the following financial participants: banks,
insurance firms, corporations, investment grade sovereign bonds, and finally, emerging
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countries sovereign debt. For example, insurance firms participate actively as buyers of
credit risk derivative instruments to hedge against sovereign risk.
The strength of credit sophisticated instruments compared to the equity market resides on
the structuring of credit derivatives that is linked to the credit quality of an institution in
the absence of tradable debt. In essence, investors are provided the opportunity to hedge
exposures to new credits inexistent in cash format.
Credit risk management aspires to implement a proactive framework destined to buffer
the probability of a counterparty failing to meet its contractual obligations. Credit play
governance intends to identify sound trading of credit derivative instruments and to
ensure secure transactions in light of market events. The credit risk analysis strives to
maintain an entity’s credit exposure methodologies in accordance with the credit risk
management mandate.
The research paper is segmented in three sections. The first section bonds the
environmental and regulatory regimes to prudently transact credit play products. The
second and third sections unravel the theoretical and mathematical foundations to discern
the retained debt derivatives in two distinct categories: simple-forms and multi-structures.
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1.0 The Credit Risk Derivative Instrument Background
The inaugurating section presents the environmental and regulatory framework to address
sage credit risk derivative trading.
1.1 The Credit Play Financial Market Risks
Financial markets expose participants to a range of risks whereas the debt threat of
damage is hedged with credit play instruments. The retained categories of market perils
from a debt hedge point of view are summarized:
Market risk: The market risk represents the possible mark-to-market depletion on
positions from adverse moves in all risk parameters. Financial entities adhere to the
following methodologies in order to address the market risk: risk appetite management,
portfolio analyses, value-at-risk simulations, stress tests, and finally, scenario analyses.
Market risk management can be performed with the described quantitative tests to
evaluate the validation and back-testing procedures for market peril modeling.
Operational risk: The operational risk reflects the business and to some extent the legal
plunge that arises from losses due to human error, litigations with various parties and
daily operational business uncertainties not considered in the other retained financial risk
categories. The administration of operational uncertainty collects and interprets the
information. It also necessitates consulting committees to justify models and regulatory
capital figures.
Equity risk: The equity risk represents the economic wastes that arise from positions
with counterparties as well as from operational ventures that are filtered to measure the
required regulatory capital. The conservation of sage equity levels safeguards the firm to
raise additional capital and to increase business with credit-worthy counterparties.
Model validation risk: The model validation risk depicts the exposure of a firm to
assess appropriate model risks and to modernize model selections. It requires a proactive
participation of various departments and third-parties to establish protocols and monitor
models. The model validation risk management implements internal controls to assess
procedures and revise pricing strategies. Various committees are established within the
firm to approve the designed arrangements.
Event risk: The event risk identifies potential plunges that derive to losses following
events that are linked to market transactions such as loan defaults and investment-grade
fixed-income downgrades.
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Counterparty risk: The counterparty risk illustrates the likelihood of peril across an
entity’s forward settlements, financial transactions and over-the-counter derivative
agreements.
Entities are therefore recommended to enforce credit risk management procedures to
buffer uncertainties in daily operations and safeguard all market participants’ confidence.
1.2 The ISDA Mechanism in Conjunction with the Dodd-Frank-Volcker
Reform
The international swaps and derivatives association (ISDA) depicts an organization
that channels financial participants to guide them in the over-the-counter derivative
market. An ISDA agreement portrays a multilateral agreement that facilitates various
over-the-counter standardized mechanisms to be processed on the basis that all parties
involved comply with the contracts. The ISDA body foresees operations in
conjunction with the Dodd-Frank-Volcker reform to provide the financial industry
with procedures and solutions that aim to safeguard sage derivative trading practices.
The American ordinance recommends swap market players to adhere to the DoddFrank protocols in collaboration with the ISDA organization that enables business
parties to secure provisions and transactions in the credit play field. Hence, the
counterparties are therefore scrutinized to enhance disclosures. In addition,
verifications are performed to validate the compliance of counterparties with the
Dodd-Frank protocols. The clearing requirements, the permitted amendments, the
regulatory regimes and other specifications related to debt derivative trading are
governed by the bilateral ISDA and Dodd-Frank protocol channeling. The merger
architecture encourages widespread information dissemination about organizations
involved in the over-the-counter market as well as delivers malleability to all parties
by permitting them to select optimal derivative transactions. The Dodd-Frank act will
be implemented in various jurisdictions and will therefore repercuss the global
financial system as an ensemble.
1.3The Credit Risk Derivative Market Arrangement
The framework of credit risk derivatives requires bonding an investor, wishing to receive
a compensation for incurred credit risk, to a hedger, aiming to honor the obligation by
removing the credit risk. The linkage between both parties relies on two parameters: the
probability of default and the recovery rate at the bond’s maturity.
The binomial tree represents the simplest form to characterize the credit risk derivative
instrument arrangement:
PBond = [1/(1+TFree)] * [(P * 100 * R) + (1-P) * 100]
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Definition of variables:
PBond: The expected bond payoff discounted from the risk-free curve.
TFree: The risk-neutral default-free rate that derives from the LIBOR or Euribor swap
curve.
P: The bond’s probability of default over the next year.
R: The recovery rate based on a fixed percentage of the face value.
In addition, the bond’s credit quality is measured by the spread derived from the credit
triangle formula:
S = [100/(PBond*(1+TFree)] -1
Definition of variables:
S: The spread which represents the annualized compensation for assuming credit risk.
PBond: The expected bond payoff discounted from the risk-free curve.
TFree: The risk-neutral default-free rate that derives from the LIBOR or Euribor swap
curve.
The spread illustrates a forward-looking compensation that encompasses for liquidity,
regulatory capital and credit risk premium to protect the bond holder for the bearing risk.
Hence, the described equations are primordial to comprehend how to price fixed recovery
default swaps and to examine cross default provisions of a firm’s debt portfolio.
Furthermore, international rating agencies provide information about the parameters
necessary to value credit risk derivatives: The default probability for various ratings and
maturities and the recovery rates relying on the level of subordination.
The credit spread curve shapes are utilized to measure the excess yield, denoted credit
spread, necessary to compensate over a determined benchmark an investor for bearing a
risk appetite.
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Figure I: The Dominant Credit Spread Curve Shapes
Inverted
Humped
Upward
The dominant credit spread curve shapes traced in the above figure and summarized with
the following description:
Inverted curve: The downward sloping yield curve is linked to credits that have
demonstrated a deteriorated credit quality with a high default probability. In
consequence, the short-maturity spread is increased and the spread curve is inverted.
Humped curve: The humped sloping yield curve occurs when credits holding a low
chance of default degrade in quality in the medium term. Hence, the credit spread with a
moderate survival rate then falls as the maturity increases.
Upward curve: The upward sloping yield curve illustrates a constant credit quality in the
short term and an elevated credit spread in the long run to compensate the investor for
increased uncertainty.
1.4 The Underlying Structure of Credit Derivative Instruments
Floating-rate notes portray a standard setting model for credit derivative pricing. In
precise terms, floating-rate notes are not defined as credit derivative products however
their existence play a prominent role in the comprehension of sophisticated financial
instruments.
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Floating-rate notes depict pure credit plays where bonds are combined to variable interest
rate indexes, based on LIBOR or Euribor, which deflate the interest rate sensitivity of the
notes compared to fixed-rate bonds. In consequence, the price adjustment of floating-rate
notes derive from shifts in the market perception of the issuer’s credit quality. This type
of product compensates investors with a higher yield to reward for credit risk and
portrays a popular tool among investment grade banks and corporations. The pricing of
floating-rate notes is generated by two methods: the floater spread and the discount
margin.
First, the price on coupon dates of the floating-rate notes depend on the following factors:
the floater spread, the maturity timeframe, the coupon, and finally, the LIBOR or Euribor
curve. Therefore, the price of this product following the floater spread method deviates
from par value following movements in the LIBOR or Euribor rate between coupon dates
and exposes the investor to reset interest rate risk.
Second, the price of this instrument induced from the discount margin method disregards
the shape of the LIBOR or Euribor forward term structure and calculates a price by
inferring a discount margin linked to a fixed spread over LIBOR or Euribor. Hence, the
Newton-Raphson mathematical logic enables to solve the discount margin.
In conclusion, floating-rate notes are metamorphosed into asset swaps to become pure
credit derivative financial instruments.
2.0 The Simple-Structure of Credit Derivative Instruments
The second component of the dissertation describes the mathematical and theoretical
regimes implicated in the simple-form of credit risk financial instruments. The selected
products are: asset swaps, default swaps, credit-linked notes, special purpose vehicles,
principal protected structures, credit spread options, bond options, and lastly, total return
swaps.
2.1 Asset Swaps
The transformation of floating-rate notes is created with asset swaps that hedge out the
interest rate risk by swapping the fixed payments of a bond to floating installments. In
essence, the investor absorbs the credit risk that is equivalent to purchasing a floating-rate
note distributed by the issuer of the fixed-rate bond. The investor is therefore rewarded
for bearing the risk with an asset swap spread quoted as a stretch from LIBOR or Euribor.
The predominant asset swap structures are initiated in two distinct trades: The asset swap
buyer, in return for an up-front payment of par which represents the first trade, receives a
fixed rate bond or enters into an interest rate swap with the asset swap seller which
depicts the second trade.
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The LIBOR or Euribor curve utilized to compute the asset swap spread implies that both
parties hold similar a credit quality rating. The asset swap spread is therefore measured
with the following equation:
SAsset Swap = (PVLIBOR/Euribor – PVMarket ) / PVBP
Definition of variables:
SAsset Swap: The asset swap spread.
PVLIBOR/Euribor: The present value of the bond price derived from the LIBOR or Euribor
swap curve.
PVMarket: The present value of the full market price of the bond.
PVBP: The present value of one-basis point annuity with the maturity of the bond.
Banking institutions depict important market participants who actively trade asset swaps
to convert long-term fixed-rate assets contained in their balance sheets to floating-rates in
order to align their short-term liabilities. However, an important element to drill in mind
derives from the fact that the buyer of an interest rate asset swap bears the fixed-side
payments in the absence of coupon funding when the bond defaults. Hence, the
counterparty default risk shall also be considered. The asset swap purchaser also loses the
redemption of the bond that is modified with compensation from a recovery rate paid by
the issuer. In consequence, the asset swap buyer holds a default contingent exposure to
the mark-to-market interest rate swap and to redeem the asset. The investor therefore
seats a leveraged position on the credit exposure and can stray from the initial
investment. The asset swap mark-to-market adaptation relies on the sensitivity of the
fixed side of the swap to parallel shifts in the LIBOR or Euribor curve. However, the
responsiveness in terms of sensibility of the bond price to parallel movements in the yield
curve is less pronounced than the sensitivity of the fixed side of the swap.
The pure play credit derivative swaps are illustrated with the following categories:
forward asset swaps, cross-currency asset swaps and callable asset swaps. The forward
asset swaps are applied when investors do not wish to bear a default risk until a forward
date. The investor then buys the credit derivative at some future date which might be
attractive than to incur a present risk with the purchase of an immediate asset swap. The
cross-currency swaps offer the investor the possibility to purchase debt in local currency
but denominated in foreign currency and receive floating-rate payments in local devise.
The bilateral devise swaps permit an investor to purchase credit risk derivatives
denominated in foreign currency while hedging interest rate and devise risk. Lastly, the
callable asset swaps enable an investor to acquire a convertible bond on an asset swap
and to receive a floating-rate coupon from the seller whereas the embedded call option is
sold separately to the equity investor. Hence, callable asset swaps aim to provide the
equity holder the right to convert the bond into the underlying stock.
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In conclusion, asset swaps depict efficient over-the-counter credit derivatives that enable
investors to grasp mispricing opportunities in the floating-rate note market.
2.2 Default Swaps
Default swaps portray simple bilateral credit play contracts intended to safeguard
investors from an asset’s default with the purchase of a protection. The specifications of
such bidirectional agreements are explicitly regulated by the ISDA. These instruments
target hedging concentrations of credit risk such as large exposures on balance sheets.
They can be customized with tailored maturity and seniority requirements for over-thecounter trades. They provide flexible investing options such as trading for the
deterioration or the improvement of a credit quality. Finally, default swaps offer an
unfunded route to bear credit risk with leveraging.
The default swap buyer disperses a fee to compensate against the loss on the investment
following a credit event. The legal credit events include bankruptcy, failure-to-pay and
restructurings. The protection holder renders a regular stream of payments defined as the
premium leg calculated from the default swap spread until a credit event arises or until
maturity. On the other hand, the vendor rewards the buyer with a payment known as the
protection leg when a credit event occurs before the maturity date of the agreement. The
protection leg equals the difference between par and the price of the cheapest to deliver
asset of the reference entity on the face value as well as indemnifies the protection
purchaser for the peril. The protection buyer is then remunerated with the following
options: cash reception after the physical delivery of a defaulted security to the seller,
sum collection that is reduced from the default price of the reference asset or lastly
remittance of a fixed cash settlement. Fixed recovery default swaps enable investors to
leverage their credit exposure and in return be compensated with a higher yield.
However, some jurisdictions require that the regulatory capital treatment of fixed
recovery default swaps be allocated in proportion to the maximum loss.
Default swap protection buyers often prefer the fixed cash settlement in order to create a
synthetic short position in a credit. It also permits the protection acquirer to end premium
payments once the credit event occurs. However, the default swap depicts a par product
that does not hedge the peril on an asset currently trading away from par value. In
consequence, the investor is recommended to consider the size of the hedge to amortize
the face value of the bond. The marking to market of a default swap unravels the changes
in the value of the default swap following the issuer’s credit quality alterations. The
adapting default swap spread therefore also reflects the cost of entering into an offsetting
transaction on a mark-to-market basis. The cash flows in the annuity are weighed by the
non-occurrence of credit event before the cash flow date.
The combined position of the protection credit play buyer and seller results in net spread
payments market-to-market with the following equation:
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SDefault Swap = [S(T+1) – S(T)] * PV1
Definition of variables:
SDefault Swap: The marking to market of a default swap.
S(T+1): The current swap spread to the maturity date.
S(T): The default swap spread at trade inception.
PV1: The present value of one-basis point zero-recovery annuity with the maturity of the
default swap that terminates following a credit event.
However, arbitrage-free relationships arise due to market dynamics whereas deviations
occur between cash and credit derivative platforms. For example, default swap spreads
can trade wider than a similar cash instrument due to the protection on the credit and
where loans are difficult to transfer. On the other hand, a default swap spread can tighten
if an investor sells a protection for a credit play in the occurrence of a lack of supply of a
corresponding cash format. Hence, investors shall consider all aspects of the trading
instruments and the market factors to determine tolerable differences between spreads in
the cash and the credit market. The dynamics in the credit market are affected as well by
liquidity injections that depend on the changes in bond maturities and the entrance of new
issues into the market. The market liquidity can therefore be examined as well by the bidoffer spread.
Default swaps are valued from models that examine a term structure of default swap
spreads and recovery rates. The risky price value of the present value of one basis point
unravels the uncertainty due to the premia payments termination following a credit event.
The calculation of the riskiness of the present value of one basis point is performed by
assessing the survival probability of the reference entity to each premium payment date.
The structural approach to modeling credit default swaps rely on the following
parameters: the default risk of the reference entity, the recovery rates, the timing of
default, and finally, the term structure of quoted default swap spreads.
The foundation of the model is illustrated with the probability of a credit event following
a Poisson distribution:
P [ Γ < t + dt | Γ ≥ t] = λ(t)dt
Definition of variables:
P [ Γ < t + dt | Γ ≥ t]: The probability of a default occurring within the time interval and
conditional on surviving to time t.
Γ: A parameter to identify a time to value the probability function.
t: A parameter to state the time interval in the probability function.
λ(t): The hazard rate of the dependant function.
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dt: The time interval in the dependant function.
The arrangement supposes that the hazard rate process is deterministic and independent
of recovery rates as well as interest rates. A one-period default modeling then arises from
a binomial tree from the above stated probability foundation, a recovery value as well as
a payment parameter (K) and that results in two distinct states; a survival probability state
that equals 1- λ(t)dt or a default state with a probability of λ(t)dt that compensates with
payment K.
The premium leg is defined as a series of payments of the default swap spread that occurs
following a default event or at maturity:
PL(tv,tN) = S(st,st+1)Σ Δ(tn,tn+1,C)LE(tv,tn+1)Q(tv,tn+1)
Definition of variables:
PL(tv,tN): The payment of premium until the time of the credit event known as the
premium leg.
N: Number of contractual payments.
tn: The maturity date of the default swap.
S(st,st+1): Default swap spread.
Δ(tn,tn+1,C): The day count fraction between premium dates tn and tn+1 in the appropriate
basis convention denoted C.
Q(tv,tn+1): The arbitrage-free survival probability of the reference entity from valuation
time tv to premium payment time tn+1.
LE(tv,tn+1): The LIBOR or Euribor discount factor from valuation date to the premium
date.
The above stated formula has to be adjusted to encapsulate the effect of premium accrued
by considering the probability of default between two premium dates as well as by
calculating the probability weighted to accrued premium payment:
PL(tv,tN)adjusted = S(st,st+1)Σ ∫Δ(tn,s,C)LE(tv,s)Q(tv,s)λ(s)ds
Definition of variables:
PL(tv,tN)adjusted: The adjusted payment of premium until the time of the credit event
known as the premium leg.
N: Number of contractual payments.
S(st,st+1): Default swap spread.
Δ(tn,s,C):The day count fraction between premium dates tn and s in the appropriate basis
convention denoted C.
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Q(tv,s)λ(s)ds: The arbitrage-free survival probability of the reference entity containing the
probability of surviving from the valuation date tv to each time s in the premium period
and then defaulting in the next small time interval ds.
LE(tv,s):The LIBOR or Euribor discount factor from valuation date to the premium date.
The effect of the premium accrued can be demonstrated by computing the difference
between the breakeven default swap spread with and without premium accrued.
The protection leg represents a contingent payment on the face value of the protection
rendered following a credit event. It is measured by evaluating the following factors: the
anticipated recovery rate which is obtained from the expected cheapest to deliver bond
into the protection at the time of the credit event, the probability of a credit event, the
survival probability at some future date and finally the timing of the credit event.
The protection leg’s expected present value of the recovery payment is formulized by:
(1 – R)∫ LE(tv,s)Q(tv,s)λ(s)ds
Definition of variables:
(1 – R): The amount to be paid deducted from the expected recovery rate.
Q(tv,s): The probability of surviving to some future time s.
λ(s)ds: The probability of a credit event in the next small increment ds.
LE(tv,s):The risk-free rate to discount the amount to be paid deducted from the expected
recovery rate.
The final step of the credit default swap requisites to calculate the breakeven default swap
spread whereas the market default swap spreads and the survival probabilities are
considered:
S(tv,tN) = ((1 – R)Σ LE(tv,tm)[Q(tv,tm-1) – Q(tv,tm)])/ RPV1
Definition of variables:
S(tv,tN): The breakeven default swap spread where the present value of the premium leg
equals the present value of the protection leg.
(1 – R): The amount to be paid deducted from the expected recovery rate.
LE(tv,tm): The risk-free rate to discount the amount to be paid deducted from the expected
recovery rate.
Q(tv,tm-1): The probability of surviving from tv to some future time tm-1.
Q(tv,tm): The probability of surviving from tv to some future time tm.
RPV1: The risky present-value of one basis point.
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The hazard term structure used in the credit default swap can be constructed with an
iterative method such as bootstrapping by considering the shortest maturity contract and
incorporating it to solution the first survival probability.
In conclusion, financiers trade credit default swaps to seek advantage in price
dislocations between the cash and default swap market. A protection purchase in the
default swap market is therefore less demanding in financial capital than shorting an
asset.
2.3 Credit-Linked Notes
Credit-linked notes depict securities that are issued by a corporate entity following an
arrangement by an investor and a financial entity. They hold an embedded credit
derivative and pay a fixed- or floating-rate coupon. These instruments are dedicated to
investors who require a cash instrument but wish an exposure in the credit derivative
market. The investor retains an exposure to the note issuer. The structure of credit-linked
notes requires an investor to purchase a note at par which then compensates LIBOR or
Euribor plus two distinct spreads: a default swap spread and a spread derived from the
issuer’s funding. In brief, credit-linked notes are used as synthetic par floaters but without
default contingent interest rate risk. If the reference asset defaults, the credit-linked note
accelerates and the investor is rewarded with the defaulted asset.
2.4 Special Purpose Vehicles
Special purpose vehicles portray bankruptcy remote trust entities that aim to repackage
credit risk structures in a securitized form destined to attract a panoply of investors. They
can therefore enhance liquidity appearances and convert existing credit derivative
instruments into cash format. In consequence, investors are protected from the
bankruptcy of a sponsor but exposed to the underlying asset or embedded option.
They promote routes to trade the following instruments: interest rate swaps, crosscurrency swaps and credit-linked notes. Firstly, investors are sometimes restricted from
directly purchasing certain credit instruments such as interest rate swaps. In consequence,
a special purpose vehicle acquires the underlying security and embarks into an interest
rate swap that enables investors to possess a note that combines the securitization of the
asset swap. If the asset in the special purpose vehicle defaults, the interest rate swap is
then closed out and the swap counterparty grasps the first recourse of liquidation
proceeds followed by the investor who collects the remaining value of the asset. A crosscurrency swap is performed when a special purpose vehicle converts an asset
denominated in a selected currency into an investor’s designated currency. The trust
purchases the foreign devise asset and enters into a cross-currency swap to exchange the
cash flows into the designated currency. The investors are however prone to devise and
interest rate risk. If a default occurs, the agreement is terminated and the swap
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counterparty is first to collect the liquidation proceeds from the defaulted asset and the
investors obtain the remaining sum from the recovery. Lastly, a credit-linked note can be
collateralized with the participation of a special purpose vehicle that acquires securities
targeted by investors and enters into a default swap with a bank that purchases a default
protection from the special purpose vehicle in question. If a default arises, the special
purpose vehicle liquidates the securities to indemnify the bank and then recompenses the
investor.
2.5 Principal Protected Structures
Principal protected structures represent a funded credit derivative that guarantee the
investor’s principal with high-grade credit transactions which limits the investor’s
participation in the reference credit. The principal protected structure illustrates a funded
credit derivative trading similarly to a credit-linked note whereas the investor is
compensated with a spread over LIBOR or Euribor. In consequence, this credit play
offers a route to market default baskets, emerging-market sovereign assets and assets
holding wide spreads.
2.6 Credit Spread Options
Credit spread options provide an investor with the choice to transact a credit view
independent of interest rates. They depict optional contracts that are exercised contingent
on the credit spread of a reference credit relative to a strike spread. In addition, the
reference asset is illustrated by a floating-rate note or a fixed-rate bond. The pricing of
credit spreads whether American or European is modeled with sophisticated
mathematical regimes. The volatility and the time-value are parameters considered to
value an option.
2.7 Bond Options
Bond options present an economical credit play destined to express a view on fixedincome instruments. They provide a hedging strategy for credit spreads, interest rates and
credit spread volatilities. Furthermore, they offer investors long and short positions to
enhance yields in the bond investment. Lastly, fixed-income options provide participants
the opportunity to hedge uncertainty about the reference credit and pursue proprietary
trading.
2.8 Total Return Swaps
Total return swaps depict a tool for balance sheet arbitrage where it is permissible to
short an asset without selling the asset to temporarily hedge credit risk as well as to take a
leveraged exposure to a credit. Total return swaps are defined as arrangements that permit
to collect all of the cash flows benefits of owning an asset without actually physically
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holding the underlying on their balance sheet. The total return swap mechanic is induced
by the total return receiver who pays LIBOR or Euribor plus a fixed spread to the total
return payer who in exchange renders a sum equivalent to the difference between the
asset’s final market price and its initial price. The total return receiver buffers the loss in
the event of a default. The pricing dynamic of total return swaps depend on the total
return payer’s funding cost and on the regulatory capital charges.
3.0 The Multi-Forms of Credit Derivative Instruments
Section 3 presents the practical applications of trading multi-structure credit risk
derivatives. The retained financial instruments are: index swaps, basket default swaps,
portfolio default swaps and finally collateralized debt obligations.
3.1 Index Swaps
Index swaps expose the investor’s total return of a universe of securities without
jeopardizing the investor to the default of any solo issuer. The index swap frame offers
the acquirer a gain or a peril in the value of the index plus any coupon accrual in return of
floating-rate payments of LIBOR or Euribor plus a fixed spread. The total return payer
therefore hedges to purchase the index. The superiority of investing in an index swap
compared to a total return swap derives from the possibility to replicate indexes with
wider bid-offer spreads. This credit play benefits participants who seek a diversified
portfolio with a significant amount of capital and who hold restricted specialized
knowledge. Lastly, index swaps are less demanding in liquidity resources than to trade all
the assets contained in the portfolio.
3.2 Basket Default Swaps
Basket default swaps portray a credit play in which credit event is described by the
default of an amalgam of credit in a specified pool of credits. They permit investors to
leverage their credit risk through the exposure of high-quality grades and be compensated
with higher yield. The basket structure enables investors to retail default protection and to
control the downside risk. In exchange, the protection acquirer indemnifies the protection
vendor with a basket spread representing a set of regular accruing cash flows. Basket
default swaps depict default correlation products that examine the covariance of assets for
risk-averse participants. The basket spread equals the sum of spreads of the reference
credits in the basket. Correlation default valuation models loop optimal dynamic hedging
strategies. In brief, basket default swaps offer investors the opportunity to trade default
correlations and increase yield compensation.
3.3 Portfolio Default Swaps
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Portfolio default swaps depict a sliced basket default swap that contains more than forty
brandings and that redistribute risks in proportion of the investor’s exposure rather than
the number of assets. The notional of the tranches in the portfolio default swap is
amortized down when the default occurs however the spread remains remunerated as a
constant percentage of the notional. The spread tranche remuneration depends on the
brandings contained in the portfolio, the number of brandings, and finally, their default
correlations. In essence, they illustrate a product that permits investors to seek an
exposure to a large group of assets with an unfunded or fully funded format.
3.4 Collateralized Debt Obligations
Collateralized debt obligations (CDO) represent an arrangement of fixed-income
securities containing cash flows that are bonded to the incidence of default in a pool of
debt products. They strive to redistribute credit risk via special purpose vehicles that emit
tranches of notes to appeal investors with distinct risk appetites. The notes however
generate payments following a waterfall structure. The mechanic of the product requisites
to issue credit play instruments from the assemblage of default bonds or loans and cash
flows are backed by the payments due on the bonds or loans. In consequence, the
occurrence of a default impacts uniquely every tranche depending on their seniority level.
The product’s pricing is determined by the rating of the instrument that considers the
shape of the portfolio loss distribution, the role of default correlation and the risk level of
the securities issued.
Arbitrage collateralized debt obligations emit credit plays to exploit differences in credit
spreads between high-yield instruments and investment-grade securities. The cash flow
collateralized debt obligation class enables to shift a portfolio of loans off the balance
sheet of a commercial bank and hence to liberate economic capital. The synthetic
collateralized loan obligations provide an entity a product to move credit risk from its
balance sheet and to reduce obligatory regulatory capital via a synthetic credit derivative.
In precise terms, an institution uses a portfolio default swap structure to relocate credit
risk with a special purpose vehicle that emits notes. In summary, synthetic collateralized
loan obligations facilitate the securitization of bulk loan transfers.
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Conclusion
The research paper delivers an enhanced understanding of credit derivatives that
combines environmental and regulatory frameworks to promote sage financial
transactions. The simple-form and the multi-structure of credit risk instruments need to
be discerned before being traded to thwart hazardous downturns. In conclusion, the
demystification of debt play products and the coherent channeling of all market
participants can strengthen optimal credit derivative management.
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U.S. Securities Exchange Commission (2010), “Dodd-Frank Wall Street Reform and
Consumer Protection Act: Specialized Corporate Disclosure”,
http://www.sec.gov/spotlight/dodd-frank/speccorpdisclosure.shtml
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