Transcript Credit Derivatives - Belmont University

Credit Derivatives
2003 – Notional value $2.31 trillion
Investment grade bonds - $3.1 trillion
Purposes
• Transfer and repackaging of credit risk
• Default baskets and synthetic loss
tranches
– New exposure to credit risk to leverage credit
risk
Credit Derivatives Market
• $2.306 trillion notional value in 2003 was a
50% increase from 2002
• Credit default swaps - 73%
• Correlation products – Synthetic loss
tranches and default baskets – 22%
• U.S companies – 43.8%
• European – 40.1%
– U.S. has a much larger cash market
• Banks – 50%
– Hedging and diversification
• Insurance companies – 14%
• Hedge funds – 13%
Credit Default Swaps
• Bilateral contract to transfer credit risk of a
reference entity from one party (protection
buyer) to another party (protection seller)
• Protection buyer – shorting credit risk
• Protection buyer makes regular payments
(usually quarterly) know as the premium
leg until credit event or maturity
Default swap mechanics
If a default occurs, there is a cash
settlement or physical settlement
Pari Passu
• From Wikipedia, the free encyclopedia
• pari passu is a Latin phrase that means "at the same
pace", and by extension also "fairly", "without partiality".
• In finance this term refers to two or more loans, bonds or
series of preferred stock having equal rights of payment,
i.e., have the same level of seniority. In asset
management firms, the term denotes an equal allotment
of trades to strategically identical funds or managed
accounts.
• This term is also often used in bankruptcy proceedings
where creditors are said to be paid 'pari passu', or each
creditor is paid pro rata in accordance with the amount of
his claim. Here its meaning is 'equally and without
preference'.
• Physical settlement – most common
– Requires protection buyer deliver notional
amount to the seller for notional amount paid
in cash. Generally, the deliverable instrument
is a basket with restrictions on maturity and
pari passu. The buyer is long a “cheapest-todeliver” option.
• Cash settlement – not generally used in
CDS, but is common in default baskets
and synthetic CDOs
CDS Maturity
• Maturity tends to be one of 4 roll dates
– 20th of March, June, September, and
December
• New contract 5-year contract on April 12th
2004 will mature June 20th 2009
• Assume contract has a spread of 160 bp
• Convention is Actual/360
• Default occurs on August 18, 2005
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$10 million notional value
Assume contract has a spread of 160 bp
Convention is Actual/360
Default occurs on August 18, 2005
Cash price of deliverable asset = $34
CDS Cash Flow
Date
July 23, 2004
Cash flow to
protection seller
$40,444.44
October 25, 2004
$41,777.78
January 24, 2005
$40,444.44
April 24, 2005
$40,444.44
July 25, 2005
$40,444.44
August 18, 2005
$10,222.22 – 6,600,000
= -$6,589,777.80
Uses of CDS
• Easy to short credit risk. Allows hedging of
credit risk or for those with a bearish credit
view.
• CDS are unfunded so leverage is possible.
• CDS are customizable in terms of maturity,
seniority, and currency. Deviation from
market standard may incur a liquidity cost.
• CDS can be used to take a spread view on
credit. A CDS can be unwound to realize
gains (or losses) owing to changes in
credit spread,
• Liquidity can be better than the cash
market. Most liquid is 5-year. 3-year, 7year, and 10-year are less liquid.
• International Swaps and Derivatives
Association (ISDA) has a master
agreement.
– Reduces legal risk, speeds up confirmation,
and therefore enhances liquidity.
• However, CDS market is not standardized.
U.S, European, and Asian markets are
segmented.
ISDA Credit Events
• Bankruptcy – corporation becomes insolvent.
• Failure to pay – reference entity does not
make due payments, taking into account a
grace period to avoid administrative error.
• Restructuring – changes in the debt
obligations of the reference creditor but
excluding those that are not associated with
credit deterioration, such as the renegotiation
of more favorable crdit terms.
• Obligation acceleration/obligation default –
Obligations become due and payable
earlier than they would have been due to
default or similar condition.
• Repudiation/Moratorium – A reference
entity or government rejects or challenges
the validity of the obligations.
Restructuring Clause
• Following bankruptcy, pari passu assets
should have the same recovery value.
• After a restructuring
– Short term may have higher value than longterm
– High coupon bonds may be more valuable
than low coupon bonds
– Loans are more valuable than bonds due to
covenants
• This makes a CDS valuable
• Consider a protection buyer with a hedge
on short-term debt trading at $80 while
long-term debt trades at $65.
– Buy the CDS, buy the long-term bond, and
make delivery. An immediate $15 profit (at the
expense of the protection seller).
• 2000 – Restructuring of Conseco
Old restructuring
• Original standard for which delivery is a
bond with a maximum maturity of 30 years
Modified Restructuring (Mod-re)
• Current standard in U.S. Roughly
speaking, it limits the maturity of the
deliverable to the maturity of the CDS
contract plus 30 months.
Modified-Modified-Restructuring
(mod-mod-re)
• Current European standard. it limits the
maturity of the deliverable to the maturity
of the CDS contract plus 60 months. It
also allows the delivery of conditionally
transferable obligations rather than only
fully transferable obligations.
No restructuring
• Eliminates restructuring as a credit event.
Restructuring and Spread
• Contracts may be available with all four
restructuring options.
• No-re will have tightest spread.
• Mod-re spread.
• Mod-mod-re more valuable than mod-re
and will have next widest spread.
• Old-re should have widest spread
CDS Formats
• Swap format (unfunded format)
– No initial payment
– Counterparty risk
• Credit-linked note (funded format)
– Buyer has to buy fund the purchase of a high
credit quality bond
– At maturity, the bond is returned to the buyer
Determining the CDS Spread
• Before credit event
Before credit event
• On the annual payment dates, hedged
investor receives
+F – D – B
At maturity, buyer receives par from asset and
repays borrowed amount
Determining the CDS Spread
• After credit event
After credit event
• Buyer delivers the defaulted asst to seller
in return for par and repays the funding
loan with this principal (assume at par)
• Strategy has no initial cost and is flat
following credit event, so CF before event
have to equal zero
No arbitrage condition
• D=F–B
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Par floater = LIBOR + 25bp
Funding = LIBOR + 5bp
F = 25bp
B = 5bp
D = 25bp – 5bp = 20bp
• Not exact
– Ignores accrued interest and coupon recovery
– Also lacks adjustments for availability of cash,
liquidity, supply and demand, and
counterparty risk
• Good starting point, and if incorrect by a
lot, arbitrage may exist
Default Swap Basis
• CDS – unfunded proxy for cash bond
• Divergence between CDS and cash bonds
is default swap basis
– Default swap basis = CDS spread – cash
LIBOR spread
• Positive basis – cash bond spread inside
CDS spread
• Negative basis – CDS spread inside cash
LIBOR spread
• Divergence between cash and CDS
spread
– Fundamental factors
– Market factors
Fundamental Factors
• 1) Funding
• If buyer borrows cash to purchase a bond,
and their credit quality is high, they may be
able to issue below LIBOR. This means it
may be better to buy bond than sell
protection in CDS. If funding cost is above
LIBOR, the reverse may be true.
• 2) The delivery option
• The cheapest to deliver option may be
valuable, so long position in CDS is more
valuable than short position. Widens CDS
spread and increases basis.
• 3) CDS protects par
• Bonds can trade above or below par
because of interest rates. Bonds with high
(low) coupons exposes the to a greater
(lower) credit risk. Bonds below par value
should pay a lower spread than the CDS,
bonds above par should pay a higher
spread than default swaps.
• 4) Counterparty risk
• Protection buyers will pay a lower spread
because of counterparty risk. Posting
collateral can reduce this risk.
Market Factors
• 1) Technical short
• Hedging of synthetic loss tranches
requires a significant amount of dealer
hedging, reducing the basis.
• 2) Convertible issuance
• Convertible equity funds use CDS to
hedge credit risk in convertibles. This
drives default swap spreads higher since
there are few outstanding convertible
bonds. Widening is usually not sustained
and reverts to normalized levels.
• 3) Demand for protection
• Negative view on credit can be traded in
two ways - Bond can be sold short or CDS
can be purchased. This can widen both
cash and default swap spread. However, it
is easier to do a CDS, so the widening of
the spread is first observed in the CDS
market.
On October 22, 2001, Enron’s stock price
dropped 20% to $20.65 per share, and fiveyear credit default swap (CDS) spreads
jumped 20% to 48 basis points, after the
Securities & Exchange Commission
announced it was looking into the firm’s
accounting practices. When Enron announced
it had overstated profits by nearly $600m over
five years on November 8, the stock was at
$8.41 and CDS spreads were at 133bp. By
the time Moody’s and S&P finally downgraded
Enron to junk status on November 28, its
stock was worth little more than a dollar per
share. Bankruptcy was filed on December 2,
2001.
• The moral of the story, ‘don’t ignore the market’, was a
hard lesson for the rating agencies to learn. Five years
on, one agency, Moody’s, has something to show for it.
• Moody’s, the oldest rating agency, and alongside
Standard & Poor’s one of the two largest agencies by
market share, has developed a set of ratings indicators
derived from market signals. These may be used as a
counterpart to Moody’s ‘normal’ ratings, which are based
on analysts’ views of an issuer’s creditworthiness.
• The indicators, dubbed ‘market implied ratings’ (MIR),
highlight discrepancies between an issuer’s credit rating
– in essence, the rating agency’s assessment of a
company’s financial situation and future outlook – and
the market’s view of that issuer – which is in effect the
sum total of the expression of all bond, credit derivatives
and equity investors’ views on that company.
It might seem like something of a no-brainer that securities the
market takes a dim view of are more likely to default; but what
is surprising is the degree to which it is true.
Using a data set of 2,900 issuers, with 180,000
observations gathered between January 1, 1999 and February
28, 2006, the one-year default rate for B2 rated issuers trading
two notches below their Moody’s rating was a massive
17.82%. That compares with a default rate of 3.61% for
issuers trading flat to their Moody’s rating; or 0.59% for those
trading two notches rich. In other words, if you held a portfolio
of bonds that were trading two notches cheaper than the
Moody’s rating, you should expect nearly a fifth of them to
default within a year.
Market implied ratings (MIR) can also be used to predict
potential ratings changes. An issuer trading three notches below
its Moody’s rating is looking at about a 25% chance of downgrade
over a one-year horizon, according to MIR data from the same
data set.
Valuing a CDS
• Value at inception is zero – no cost to
enter
• Value will change over time
• At inception:
– E(PV) protection leg = E(PV) premium leg
• Mark-to-market (MTM) value is the value
the market would pay us to unwind the
position
• Suppose a 5-year CDS was issued at a 250bp
spread. In one year, the spread on the reference
entity falls to 100bp.
• MTM = E(PV) of premium leg of 250bp
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- E(PV) of 4-year protection leg
• New 4-year CDS:
• E(PV) of premium leg of 250bp
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- E(PV) of 4-year protection leg
• Substituting:
• MTM = E(PV) of premium leg of 250bp
• - E(PV) of 4-year premium pmts 100 bp
• MTM = E(PV) of premium leg of 150bp
• Discount PV of 150bp payments.
However, payments are made only until
credit event, so:
• MTM = 150bp * RPV01
RPV01 = risky PV01 of a 1bp paid on
the premium leg. Calculating the RPV01
requires a model that uses market spreads
to determine probability of default.
Bloomberg – CDWS function
Basket Default Swaps
(or default baskets)
• Synthetic correlation products that
redistribute the risk of a portfolio of 5 to
200 CDS.
• Similar to a CDS, except that the nth credit
event is the trigger. The first-to-default
(FTD) basket takes the first defaults.
Protection seller receives a spread based
on the notional value until the nth credit
event or maturity.
• A basket default swap exposes the
protection seller to the tendency of the
assets to default together, or default
correlation.
Why?
• Consider a reference portfolio with CDS
spreads of 30bp, 30bp, 27bp, 29bp, and
30bp. The FTD basket may pay 120bp. A
more risk averse investor could take the
second-to-default (STD) basket or lower.
Valuing a Default Basket
• Value of n – A FTD is riskier than a STD
and commands a higher spread.
• Number of credits – The more credits in
the basket, the greater the likelihood of
one or more credit events, so the higher
the spread.
• Credit quality – The lower the credit quality
of the credits, the higher the spread,
• Maturity – The effect of maturity depends
on the shape the individual credit curves
and the correlation of the term structure.
• Default correlation – The greater the
default correlation, the greater the spread.
Use of Default Baskets
• Investors can leverage credit exposure and
get a higher yield without increasing notional
at risk.
• Reference credits are typically investment
grade and require little extra analysis.
• Basket can be customized for the investors’
exact view regarding notional value, maturity,
number of credits, credit selection, and the
order of protection (FTD, STD, etc.)
• Default baskets can be more cheaply used
to hedge a portfolio of credits than hedging
individually.
• Can be used to express a view on default
correlation.
Synthetic CDOs
• Similar to default basket
• Example:
• 100 CDS pool, $10 million notional value
each. 3 tranches:
– $50 million equity tranche, $100 million
mezzanine tranche, $850 million senior
tranche
• Spreads
– Equity tranche: 1500bp
– Mezzanine tranche: 200p
– Senior tranche: 15bp
• A default in 1 of the 100 with a 30%
recovery rate ($7 million loss).
• Equity tranche loses $7 million of value.
• Equity tranche notional value is now $43
million. The spread is now paid on this
new value of $43 million.
• The process is repeated until $50 million
losses are incurred. At that point the equity
tranche is depleted and losses now accrue
to the mezzanine tranche.
CDOs and beyond
• A CDS is a derivative.
• CDOs are a double derivative.
• There are triple derivatives. A CDO made
up of CDOs.