Transcript Com 4FJ3 - McMaster University

Com 4FJ3
Fixed Income Analysis
Week 12
Credit Derivatives and Review
Credit Derivatives
• Similar to the way interest rate derivatives
allow the transfer of some of the interest
rate risk, credit derivatives allow an investor
to transfer credit risk to others
• These derivatives are often more efficient to
use than actual cash market postions
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Types of Credit Risk
• Default risk
– the issuer of the security fails to make the
promised payments
• Credit spread risk
– due to a credit upgrade or downgrade, the
required yield spread over treasury changes,
affecting the price of the bond
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ISDA
• International Swap and Derivatives
Association
• Since 1998 has set standard contracts for
credit default swaps and total return swaps
• The contracts are flexible enough to use for
the other derivatives listed
4
References
• The contracts are based on some underlying
security, referred to as:
– reference entity or reference issuer; the firm
that issued the bond and who’s credit risk is
being transferred
– reference obligation or reference asset; the
particular bond issue (or other debt instrument)
that is being protected
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Credit Events
• Many of the derivatives pay off when a
particular event happens
– Bankruptcy
– Failure to pay
– Obligation acceleration; the firm violates a term
in the covenant making the bond due & payable
– Repudiation/moratorium; rejecting the above
– Restructuring; controversial, see next slide
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Restructuring
• Prior to seeking bankruptcy protection, a
debtor can make a proposal to creditors or
seek a restructuring of their debt
• Problematic due to the discretion of the
holders of the debt to accept the proposal
• IDSA form has 4 different methods of
handling restructuring in the contract
– none, all, modified and modified modified
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Asset Swap
• Not strictly a credit derivative since credit
risk is not traded
– Own a bond paying fixed coupons, enter a swap
agreement to trade fixed for floating payments
– Sell the asset to a dealer with a swap agreement
and an obligation to buy back the bond if there
is a credit event
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Total Return Swap
• A swap agreement where one party makes
floating rate payments and the counter party
makes payments based on the total return
(interest and capital gain/loss) of the
reference obligation
• Cash flow of the total return payer is similar
to short selling the reference obligation and
investing the proceeds
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Credit Default Swap
• Buyer pays a premium (a % of the notional
amount), on a quarterly basis, to protect
against default
• In the event of a credit event, the seller of
the swap buys the underlying asset from the
buyer for the notional amount
• Can be based on a basket of assets
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Credit Spread Options
• Underlying is a reference obligation
– a call or put option where the strike price is not
fixed but based on a fixed spread over treasury
• Underlying is the credit spread
– a cash settlement contract where the payoff is
based on the difference between the reference
obligation’s credit spread vs. the strike spread
x notional amount x risk factor
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Credit Spread Forwards
• Similar to the difference between forward
contracts and option contracts on any other
commodity
• Related to a credit spread option, but the
final settlement is not based on one party
having the choice to exercise, so no option
premium is required
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Structured Credit Products
• Debt instruments with payoffs linked to the
credit performance of reference obligations
• Synthetic CDO: Invests in low risk assets
and sells credit protection derivatives
– Dominates the CDO market
• Credit-linked notes: short term debt, 1 - 3
years; if the reference asset defaults the note
is paid off early and at a discount
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Rapid Review
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Call Protection
• Most commercial mortgages do not allow
free prepayments
–
–
–
–
Prepayment lockout
Defeasance
Prepayment penalty points
Yield maintenance charges
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Balloons
• Commercial mortgages typically have a
balloon maturity provision
• Lender may allow an extension if the
borrower has difficulty refinancing, but
charge a higher default interest rate
– The possibility of default on the balloon
payment is called balloon risk and, with the
above provision can be a form of extension risk
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Services
• Can have a single servicer or multiple
– Sub-servicer; collects cash and information
– Master servicer; oversees the deal, verifies
details of the agreement, makes timely payment
of interest and principal (even when there are
late payments)
– Special servicer; deals with accounts more than
60 days overdue
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Credit Enhancement
• As with MBS, asset backed securities often
include credit enhancement to get the credit
rating the issuer desires
– External enhancement; insurance, corporate
guarantees, letters of credit
– Internal enhancement; reserve funds, overcollateralization, senior/subordinated structure
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Static Spread
• Find the treasury spot rate term structure
using the bootstrapping method
• Find the present value of the cash flows for
the bond using the spot rate plus a spread
• Solve for the spread that gives the current
price
• Called the static or zero volatility spread
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Negative Convexity
• The normal price/yield curve is convex
• With price compression the level of
convexity can become negative (technically
it is now concave)
• Price change from increasing interest rates
becomes larger than the change from falling
interest rates
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Interest Rate Volatility
• The major influence on the price of a bond
is interest rates
• Changes in interest rates can be measured
over time and the volatility can be estimated
• Can be used to create an interest rate model
• Textbook model is single factor, lognormal
random walk, binomial interest ladder or
lattice, estimating potential forward rates
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Convertible Bonds
• Another type of embedded option
• A call option on a number of the issuer’s
common share where the exercise price is
the bond, regardless of current market value
• Number of shares is conversion ratio
• Can be physical or cash settle
• Exchangeable bonds are similar options, but
on other company’s shares
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Minimum Price
• The bond will trade at a minimum of the
greater of the conversion value or straight
(debt) value
– conversion value: how much the stock that the
bond can be converted to is worth
– straight value: the value of the convertible if it
did not have the conversion option
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Market Conversion Prices
• Since the exercise price is the bond, the
effective price of the common stock
changes over time
Market conversion
price
=
Market price of bond
Conversion ratio
Market conversion
premium per share
=
Market conversion price
Market conversion
premium ratio
=
Conversion premium per share
Market price of common stock
-
Current
market Price
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Jargon
• A convertible where the option is well out
of the money is called a bond equivalent or
busted convertible
• A convertible with a conversion value much
higher than its straight value is called an
equity equivalent
• Between those it is a hybrid security
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Options Approach
• Similar to callable bonds, convertibles can
be viewed as a bond and an option
• An additional problem here is that the
exercise price on the share changes over
time as the bond’s market price is affected
by changes in interest rates
• To make matters worse, most convertible
bonds are also callable
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Futures
• Similar to a forward contract in the fact that
it binds both parties to a specific transaction
in the future… but
– A futures contract is standardized with respect
to the quantity, quality, time, and location
– Contracts are traded on organized exchanges
– No specific link between the buyer and seller
– Gains or losses are realized on a daily basis
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T-Bill Quotes
• T-bills are quoted on the annualized yield on
a bank discount basis
D 360
Yd  
F
t
t
D  Yd  F 
360
Yd  Annual yield as a decimal
D  Dollar discount
F  Face value
t  Days to maturity
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T-Bill Futures Prices
• Quoted on an index basis
index price = 100 - (Yd x 100)
• Given a current quote of 3.75% for T-bills
index price = 100 - (3.75) = $96.25
• Given a futures price of $92.50 the yield is
100  index price 100  92.50
Yd 

 0.075  7.5%
100
100
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Invoice Price
• This is how much is paid for the t-bill if it is
delivered
• Invoice price = $1,000,000 - D
• Find the invoice price if the final settlement
price is $92.50
91
D  0.075 $1,000,000
 $18,958.33
360
Invoice $1,000,000 D  981,041.67
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Treasury Bond Futures Details
• Price quoted per $100 of face value
• Price quoted in $1/32
96-13 means $(96 + 13/32) = $96.40625
• Invoice price = Contract size (face value/100)
x settlement price
x conversion factor
+ accrued interest
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Cheapest to Deliver
• Given a choice sellers will want to figure
out which issue is the cheapest to deliver
• Face value of issue is set at $100,000 but
actual price is affected by conversion ratio
• Find implied repo rate   Invoice 
 Cost 
t
365
1
• Highest repo rate is the cheapest to deliver
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Theoretical Price
• Assuming short sales, we can also do the
reverse, so we can get a theoretical price
• profit = 0 = proceeds - outlay
• F = P(1 + t(r - c))
F = futures price
P = Current bond price
t = time to delivery
r = financing cost
c = current yield on underlying bond
• (r - c) called cost of carry
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Option Basics
• Options are based on buying or selling an
asset in the future at a fixed price
• This transaction is not guaranteed to take
place
• With an option one party to the option
decides whether or not the transaction will
be completed on the specified date
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Option Basics
• The option has given one party the right but
not an obligation to buy or sell the asset at
the fixed price
• As you might guess, this party has to pay
the other party for this privilege
• The payment is called the option premium
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Call Option Price
Value
option price
intrinsic value
Exercise Price
Market
Price
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Futures Options
• The right to enter into a futures contract at a
pre-specified price
• Call option: the right to take a long position
• Put option: the right to take a short position
• If exercised, the futures contract is written
at the specified price, and immediately
marked to market by the exchange
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Interest Rate Swaps
• Main idea is to trade fixed rate interest
payments (receipts) for floating rate
payments (receipts)
• Swaps have counterparty risks since they
are not traded on organized exchanges
• May involve a securities firm or
commercial bank as a broker or dealer
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Interpreting a Swap
• There are 2 ways of looking at a swap
• A package of forward contracts
• A package of cash market instruments
– Buy a 9% fixed coupon $50m bond
– Finance by borrowing $50 at LIBOR
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Beyond Plain Vanilla
• Varying principal swaps: the principal on
which interest is calculated changes over
time… often for amortizing securities
• Basis swaps: exchanging floating rate
payments based on different reference rates
– Constant Maturity Swap: one of the reference
rates is the constant maturity treasury (CMT)
rate published by the federal reserve
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Beyond Plain Vanilla
• Swaptions: an option to enter into a swap
contract at a point in the future
• Forward start swap: a swap contract were
the start date of the swap is in the future
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Caps and Floors
• Interest rate agreements include
–
–
–
–
–
The reference rate
The strike rate (cap or floor)
The length of the agreement
The frequency of settlement
The notional principal
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