Transcript Energy Finance and Credit Summit 2004 Risk Limited, Sungard and Deloitte (Sponsors) Four Seasons Hotel, Houston, Texas Friday, February 27, 2004 Leslie K.

Energy Finance and Credit Summit 2004
Risk Limited, Sungard and Deloitte (Sponsors)
Four Seasons Hotel, Houston, Texas
Friday, February 27, 2004
Leslie K. McNew
Clinical Professor, Finance and Director of the Trading Center
AB Freeman School of Business, Tulane University, New Orleans
504-865-5036
[email protected]
Credit Derivatives
Growth in Credit Derivatives Market
British Bankers Association Survey Credit Derivatives (US $
Billions)
800
700
600
End 2001: $1.2 Trillion
End 2002: $1.5 Trillion
US $ bn
500
400
300
200
100
0
1996
1997
1998
1999
2000
1
Growth in Credit Derivatives Market
Credit Derivatives
• Newest of the derivative markets
• Developed around 1992-1993
• Used to manage and exploit risks/opportunities in credit markets
• Risk transferred among participants----off or on balance sheet transactions
Off balance-sheet
On balance-sheet
Credit default swaps
credit linked notes
total rate of return swaps CDO's (collateralised debt obligations)
2
Growth in Credit Derivatives Market
London is the dominant financial center
• Size of the international debt market
• A market-friendly regulatory environment
• Liquid asset swap market
• Derivative strengths
3
Definitions
Credit Derivative:
Credit Default Swap:
Digital Derivative:
Total Return Swap:
LIBOR:
Credit Spread:
Off-balance sheet:
a credit derivative allows the holder to isolate and
separate credit risk from market risk, thus
allowing this credit risk to be either hedged, traded,
or transferred. A premium may be due.
enables isolation and transfer of credit risk without
transferring ownership of the asset
cash settled transaction (does not need delivery of
underlying asset upon settlement)
transfer credit risk by swapping an underlying asset’s
specified total return (capital growth and interest)
between two counterparties, in return for regular
payments of LIBOR + spread
the London inter-bank offer rate. The inter-bank rate
used when one bank borrows from another. It is also
the benchmark used to price many capital market and
derivative transactions.
difference in ‘yields’ between an agreed reference
rate and a specific asset in question.
London: gilt market
US: treasury market
instrument or trade does not have to be admitted to
the firm’s balance sheet (can be ‘hidden’)
4
Credit Derivative ‘Trigger’ Events
• Payment default or bankruptcy/insolvency in the case of corporate credits
• Moratorium on payments or the rescheduling of payments, as well as payment default
itself, for sovereign credits
• Chapter 11 or bankruptcy filing by the issuer
• failure to meet payment obligations when due
• rating downgrade below an agreed upon level
• change in the agreed credit spread (over a government bond or compared to another
government bond)
A materiality threshold (a significant price decline) has also to be breached and
independently agreed.
5
Fee Determinants for Credit Derivatives
• credit rating or probable swap counterparty
• maturity
• probability of default
• expected value of the asset (post-default)
assumed mark to market risk of per counterparty:
Porfolio Simulation
Name
Ticker
Duke Energy Corp
DUK
American Electric Power
AEP
Sempra Energy
SRE
Reliant Energy Inc
REI
El Paso Electric Co
EE
Southern Co
SO
Dynergy Inc
DYN
Value of Credit Unit Trust Today
Ratings
A
A
A
BBB
BBB
BBB
BBB
Industry
utility
utility
utility
utility
utility
utility
energy
1 yr offer
82
80
570
127
136
131
126
$10,000,000
Pricing
$82,000
$80,000
$570,000
$127,000
$136,000
$131,000
$126,000
$1,252,000
Prices from around the time of the California energy crisis
Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005
6
Why Use Credit Derivatives? Protection Buyer
4 Main Reasons
1. Reduce exposure to a company or bank whose credit
rating is deteriorating
2. To free up credit lines so that higher margin businesses
may be transacted
3. To protect against a downgrading below a portfolio
manager’s internal limits
4. To reduce credit exposures which have exceeded limits,
possibly where interest rates or currency movements
have exceeded expectations
7
Credit Default Swap: in Energy Market
• Energy Company has a large exposure to Duke due to trading activities
• Energy Company wishes to reduce default risk to Duke
• Energy Company buys credit derivative from Investment Bank to reduce (‘insure’) Duke
credit risk exposure: purchases a DITIGAL instrument
• Investment Bank only pays out notional amount to Energy Company if Duke experiences
a default event (see “Triggers”)
assumed mark to market risk of per counterparty:
Porfolio Simulation
Name
Ticker
Ratings
Duke Energy Corp
DUK
A
$10,000,000
Industry
utility
1 yr offer
82
Pricing
$82,000
$
Energy Company
Investment
Bank
Receive $ notional
amount of credit
protection
Energy Company pays 82
basis points to receive,
within 1 year, $10 M from
the Investment Bank if
Duke Energy defaults
If Duke defaults within one year, the Energy company owns default ‘insurance’ that will
pay $10 M regardless of the amount of the Duke default
10
Total Return Swap
Instead of lump sum notional payment in the event of default, the protection buyer receives
a specified economic value for the reference credit.
Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protection
Total Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protection
Reference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure
Total Return of Asset
Total Return Payer (X)
Reference
Asset
Total Return Receiver (Y)
LIBOR + spread
• Energy Company (X) pays any appreciation on the capital value of the underlying asset as well as
any coupons receivable
• Investment Bank (Y) pays Energy Company (X) any depreciation of the capital value as well as a
LIBOR linked floating margin
• Energy Company (X) is guaranteed a specified capital value for the underlying, as well as a LIBOR
linked income for the duration of the swap
• Investment Bank (Y) ‘owns’ the credit risk, as well as any income and any profits generated by this
asset
• Energy Company (X) retains the ownership of the reference asset, and must continue to fund the
asset (reference asset)
• If there is no credit event, there will be no contingent payment
11
Total Return Swap
Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protection
Total Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protection
Reference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure
Total Return of Asset
Total Return Payer (X)
Reference
Asset
Total Return Receiver (Y)
LIBOR + spread
Why Use Total Return Swaps?
• lock in a specified economic value for the duration of the swap
• transfer the market risk of an asset off-balance sheet to lower regulatory charges
• used for trading credits on a leverage off-balance sheet basis
12
Credit Spreads
Credit Spread:
difference in ‘yields’ between an agreed reference
rate and a specific asset in question.
London: gilt market
US: treasury market
Example:
T0 Corporate bond trades at 55 basis points over gilt
T1 Corporate bond now trades at 45 basis points over gilt
• the credit spread has ‘narrowed’ (‘tightened’)
• credit quality of bond/bond issuer has improved
WIDER CREDIT SPREADS IMPLY MORE LIKELY
CHANCE OF DEFAULT
13
Credit Spreads
2 Distinct Versions:
Credit spread relative to benchmark
Credit spread between two ‘credit-sensitive’ assets
Easiest way to enter transaction is through OPTIONS
Credit spread options enable trading/hedging of changes in
credit quality of the specified reference credit
Strike set at a particular credit spread
14
Credit Spread Options
Payoff:
C[spread(T);(K)] = (spread(T) – K) x notional amount x risk factor
Where
Spread(T) =
K =
Notional amount =
Risk Factor =
the spread for the financial asset over the risk-less rate at the
maturity of the option
the specified strike spread
a contractually specified dollar amount equal to the amount
that needs to be hedged
based on measures of duration and convexity
For a description of duration, convexity and other financial calculations, purchase
‘Mastering Financial Calculations,’ Robert Steiner, Financial Times/Pitman Publishing,
1998, refer to chapter 5 for bond market calculations, and chapter 9 for options
15
Credit Spread Options
1.
2.
3.
4.
5.
Energy Company X is concerned about a ‘credit downgrade’ of one of its counterparties
Current counterparty is trading “A” rating, Energy Company X is concerned it will be
downgraded to a “B”
Energy Company X buys ‘downgrade’ protection in the form of a credit spread option
If the credit spread on its counterparties widens, downgrade from “A” to “B”, Energy
Company X receives a payout
Energy Company X buys a call option on the credit spread (widening spread) and pays a
premium
INPUTS
notional
current spread
strike
duration
risk factor
current credit rating
$1,000
150
150
1 year
1.867
A
In basis points
In basis points
PROTECT AGAINST A CREDIT DOWNGRADE FROM 'A' TO 'B'
PROTECT AGAINST CREDIT SPREAD WIDENING --- POTENTIAL FOR DEFAULT INCREASING
Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005
16
Credit Spread Options
Payout Profile of a Credit Migration Downward Option
$76.00
$64.00
option payout
$52.00
$40.00
$28.00
$16.00
$4.00
-$8.00
-$20.00
Payment of
premium
Breakeven
Credit spread has widened from 150 bps to 300
bps after 1 year, and option pays out
Option payout = change in credit spread x notional amount x risk factor
Option payout = [(300-150)/10,000] x $1,000 x 1.867 = $28.00
17
First to Default Basket Options: Notional Payout
Just as a portfolio manager may purchase protection on a single name (credit), said manager may
also purchase protection on a basket of names (credits): two or more.
In the case of the FIRST TO DEFAULT STRUCTURE, the credits in the ‘basket’ are protected
against default for a set notional amount. The risk credit to default triggers the basket payout and
basket termination. At this point, the other credits are left un-hedged, and most be re-hedged.
FIRST TO DEFAULT BASKET
Duke Energy Corp
American Electric Power
Sempra Energy
Reliant Energy Inc
El Paso Electric Co
Southern Co
Dynegy Inc
$10 M Notional Total
$
Investment
Bank
Energy Company
X
NexCollateral receives $10
M if ONE of the basket’s
participants defaults
FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance
18
First to Default Baskets vs. Straight Credit Default Derivatives
outright credit default derivatives
assumed mark to market risk of per counterparty:
Porfolio Simulation
Name
Ticker
Ratings Industry 1 yr offer
Duke Energy Corp
DUK
A
utility
82
American Electric Power
AEP
A
utility
80
Sempra Energy
SRE
A
utility
570
Reliant Energy Inc
REI
BBB
utility
127
El Paso Electric Co
EE
BBB
utility
136
Southern Co
SO
BBB
utility
131
Dynergy Inc
DYN
BBB
energy
126
Value of Credit Unit Trust Today
Credit Default Option on Basket
assumed mark to market risk of per counterparty:
Porfolio Simulation
Name
Ticker
Ratings Industry 1 yr offer
Duke Energy Corp
DUK
A
utility
American Electric Power
AEP
A
utility
Sempra Energy
SRE
A
utility
Reliant Energy Inc
REI
BBB
utility
El Paso Electric Co
EE
BBB
utility
Southern Co
SO
BBB
utility
Dynergy Inc
DYN
BBB
energy
Basket Cost
457
Value of Credit Unit Trust Today
Cost Savings by Using Default Basket
$10,000,000
Pricing
$82,000
$80,000
$570,000
$127,000
$136,000
$131,000
$126,000
$1,252,000
$10,000,000
Pricing
$457,000
$795,000
COST SAVINGS
FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance
19
PRACTICAL EXAMPLES
APPENDIX E - CREDIT RISK LIMITS
Table 1: Portfolio Mix Limits, secured by parental guarantees
Maximum % of
**Rating
AAA
AA
A
BBB
Max. Tenor
3 years
3 Years
3 Years
(1)
2 Years
Outstanding Exposure
By Rating Category
N/A
N/A
50%
30%
Collateral (security) comes in different formats:
 Cash
 Securities
Can be converted to cash in case of default
 Treasuries
 Surety Bonds
 Letters of Credit
 Parental Guarantees
Promise made on behalf of parent to secure activity undertaken by
subsidiary, to a specific entity (contractual form). At current time, promise
only secures the pre settlement and settlement risk of actual transactions, no
VaR or liquidated damages. Specific entity usually must seek legal recourse
to recover against this form of collateral in the case of default.
In Energy industry, large percentage of trading partners
rated BBB or less, and the convention is to secure transactions
with parental guarantees
20
PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives
APPENDIX E - CREDIT RISK LIMITS
Table 1: Portfolio Mix Limits, secured by parental guarantees
Maximum % of
**Rating
AAA
AA
A
BBB
Max. Tenor
3 years
3 Years
3 Years
(1)
2 Years
Outstanding Exposure
By Rating Category
N/A
N/A
50%
30%
Problem:
1. Corporate does not want to have significant portfolio exposure
to BBB risk
2. Corporate does not want to have significant portfolio exposure
to parental guarantees as security
3. Energy industry, as practice, transacts on parental guarantees
4. Energy industry participants heavily weighted toward BBB
5. Need large liquid pool from which to transact to make $$$$
21
PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives
APPENDIX E - CREDIT RISK LIMITS
Table 1: Portfolio Mix Limits, secured by parental guarantees
Maximum % of
**Rating
AAA
AA
A
BBB
Max. Tenor
3 years
3 Years
3 Years
(1)
2 Years
Outstanding Exposure
By Rating Category
N/A
N/A
50%
30%
Answer:
Secure all BBB parental guarantee participants beyond 30%
threshold with credit derivatives
Name
Reliant Energy Inc
El Paso Electric Co
Southern Co
Dynergy Inc
Ticker
REI
EE
SO
DYN
Ratings
BBB
BBB
BBB
BBB
Industry
utility
utility
utility
energy
1 yr offer
127
136
131
126
Pricing
$127,000
$136,000
$131,000
$126,000
Mitigate the portfolio credit risk by buying protection
22
PRACTICAL EXAMPLES
Apply Credit Derivatives to Policy Objectives
Credit Report
Counterparty Symbol
Reliant
REI
Rating
BBB
Credit
Month A/R
Available
Limit
Prior
Current
MTM
VaR
Credit
$15,000,000
$3,120,000
$227,868
$7,869,873
$2,298,429
$1,483,830
Rating
BBB
Credit
Derivative
Limit
Notional
bps
$15,000,000 $15,000,000
Credit Hedge Report
Counterparty Symbol
Reliant
REI
cost
127
Portfolio Credit
Exposure
$190,500
$0
Individual Counterparty Hedge:
1. Set traditional credit limit
2. Purchase protection in form of default credit derivative against credit limit
(limit and notional amount must match)
3. Mitigate all credit exposure to counterparty by above off-balance sheet
transaction (transferred risk to AA rated investment bank --- always risk
that said bank will default)
4. Monitor available credit such that it does not exceed credit limit
5. Charge traders or profit center for cost of credit derivative
6. 100% compliance with policy while still allowing trading liquidity
23
PRACTICAL EXAMPLES
Counterparties Over Credit Limit
Counterparty Symbol
Reliant
REI
Rating
BBB
Credit
Month A/R
Available
Limit
Prior
Current
MTM
VaR
Credit
$10,000,000
$3,120,000
$227,868
$7,869,873
$2,298,429 -$3,516,170
Problem/Resolution:
1. Traders/marketers put deal in system that breaches credit limits
2. Discipline action required (see policy)
3. Company now exposed to greater risk than desired
4. Purchase default derivative to cover risk until situation can be resolved
5. Charge person/group responsible for cost of protection (against their P/L)
Credit Hedge Report
Counterparty Symbol
Reliant
REI
Rating
BBB
Available
Derivative
Credit
Notional
bps
-$3,516,170
$5,000,000
cost
127
Available
Credit
$63,500
$1,483,830
24
PRACTICAL EXAMPLES
Credit in High Volatility Months
5.3.5. Period of High Volume and Extreme Price Volatility.
Periods of Extreme Price Volatility and/or Peak Volumes
At certain times during the year the company may enter periods of high transaction
volume and/or extreme price volatility. These circumstances may cause a significant
percentage of the company’s counterparties to exceed their credit limit. From a
business standpoint, it is not practical to cease all trading with such counterparties
during periods such as these, thus significantly limiting trading options and liquidity. If
the Vice President of Risk Management, the Senior Management, and the Risk
Management Steering Committee determines that the company is in such a period, they
may instruct the Director of Credit to implement credit limit overrides based upon the
following guidelines:
Rating
AAA
AA
A
BBB
% of Credit Limit
Override
25%
25%
20%
20%
$$ Limit of
Override
$ 5 million
$ 4 million
$ 3 million
$ 1 million
Example, summer is high volatility
for power. Keep the deals on the book,
get paid for the extra risk that the
company is taking.
Power Forward Price Curve
$160
$140
$120
$100
$80
$60
$40
$20
$0
Fe
M
Ap
F
M
Ju
Ju
Au
Se
O
N
D
Ja
ar
ov
ec
ct
a
br
nl
n- eb-9
9 9 -99 g -9 p -9
0
99 -99 -99 y -9
00
9
9
9
0
9
9
9
9
9
25
PRACTICAL EXAMPLES
Credit in High Volatility Months
Total Return Swap
Total Return of Asset
Energy Company (X)
Dynegy
Investment Bank (Y)
LIBOR + spread
lock in a specified economic value for the duration of the swap
1.
2.
3.
4.
5.
Energy Company X will raise credit limits during high vol
months
Energy Company X takes on more risk during this period and
wishes to be compensated for said risk
Total return swap pays Energy Company X a rate equal to
LIBOR + spread, and any depreciation on asset (Dynegy)
Energy Company X pays investment bank any appreciation on
asset (Dynegy)
Energy Company X earns a higher rate of return during the
swap, which compensates it for the increased risk that it is
assuming
26
PRACTICAL EXAMPLES
Problem
1. Rumors in energy industry indicate that problems are brewing
in California market (possibility of credit defaults)
2. Energy company X has large position due to trading
transactions with PG&E
3. Energy company X wants a credit hedge to offset against any
cash flow problems PG&E may incur (credit manager is hearing
rumors, and wants some protection, but not costly protection
4. Energy company X credit manager buys credit spread call
(credit widening---possibility of default greater), struck at
current spread level, on PG&E
5. Energy company X credit manager buys call against current
mark to market position (notional amount of call equals current
mark to market credit risk position with PG&E)
27
PRACTICAL EXAMPLES
Credit Spreads Against Credit Migration Downward
Payout of PG&E Credit Migration Downward Credit Spread
Option
$1,400,000.00
$1,200,000.00
option payout
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
$0.00
Payment of
premium
Breakeven
Credit spread has widened from 72 bps to 600
bps after 6 months, and Energy Company X gets
out of option
Current credit spread is
72 bps., and credit
manager sets notional
amount at $10 M.
Credit spread widens to
600 bps after 6 months,
and the option pays out
over $3 M. If the credit
manager had been
wrong on acting on the
rumor, the cost of the
option would have been
minimal. As it was, the
credit manager acted,
and although PG&E did
not default, the spread
widen to compensate the
credit manager for the
extra risk her portfolio
had taken to transact
with PG&E
28
Optimal Credit Protection Column
Parental Guarantees
Payoff based on recovery percentage
Credit Derivatives
Letters of Credit
All of
payoff in
event of
default
situation
Credit Portfolio Insurance
29
Using Bloomberg
Type in stock ticker (AEP)
After stock ticker, space, type “CORP”
GO
Select Corporate Bond desired for analysis
Example of a List of Corporate Bonds
30
Using Bloomberg
Select Corporate Bond
Then, when inside bond, ASW GO
corporation
31
Good way to get an estimation, actual quotes differ by 20-50 bps.
Date
2/20/2002
2/12/2002
2/4/2002
1/25/2002
1/17/2002
1/9/2002
1/1/2002
12/24/2001
12/14/2001
12/6/2001
11/27/2001
11/19/2001
11/9/2001
11/1/2001
10/24/2001
10/15/2001
10/5/2001
9/26/2001
9/13/2001
9/5/2001
8/28/2001
8/20/2001
8/9/2001
8/1/2001
7/24/2001
7/16/2001
7/6/2001
6/28/2001
6/19/2001
6/8/2001
5/30/2001
5/22/2001
5/14/2001
5/4/2001
Basis Points
Using Bloomberg
American Electric Power Basis Spread (5-Year Bond)
160
140
120
100
80
60
40
20
0
32