1、Chapter 30 Credit Derivatives Learning ObjectivesAfter reading this chapter, you will understandq what a credit derivative isq the different types of credit riskq what an asset swap isq what a credit default swap is and how a credit event can be definedq the difference between a single-name credit d
2、efault swap and a basket default swapq the valuation of a single-name credit default swapq what a credit default index isLearning Objectives (continued)After reading this chapter, you will understandq credit default swaps on municipal securities, asset-backed securities, and credit debt obligationsq
3、 what a total return swap is and the types of risk faced in such a swapq the different types of credit optionsq what a credit forward isq securities that are created using credit derivatives: synthetic collateralized debt obligations and credit-linked notesTypes of Credit RiskqAn investor who lends
4、funds by purchasing a bond issue is exposed to three types of credit risk:i.default riskii.credit spread riskiii. downgrade risk.qDefault risk is the credit risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amoun
5、t borrowed.qCredit spread risk is the risk that an issuers debt obligation will perform poorly relative to other bonds due to an increase in its credit spread.If the credit spread increases, the market price of the bond issue will decline (assuming Treasury rates have not changed).qDowngrade risk re
6、fers to an unanticipated downgrading of an issue or issuer that will cause the credit spread to increase resulting in a decline in the price of the issue or the issuers bonds.Downgrade risk is closely related to credit spread risk.Categorization of Credit Derivativesq There are several ways to chara
7、cterize credit derivatives.One such categorization is shown in Exhibit 30-1 (see Overhead 30-6).As we shall see, some of the derivatives described in the exhibit are not true credit derivatives in that they do not provide protection against credit risk.Rather, they provide protection against both in
8、terest rate risk and credit spread risk.This applies to asset swaps and total return swaps.Credit default products provide protection against credit events.Exhibit 30-1 Categorization of Credit Derivatives Credit DerivativesAsset SwapsTotalReturnSwapsCreditDefaultProductsCreditSpreadProductsCreditDe
9、faultSwapsDefaultOptionsCreditSpreadForwardsCreditSpreadOptions SingleNameSwapIndexSwapsUnderlyingis credit-risky bondUnderlyingis a creditspreadBasketSwapsISDA Categorizationq Prior to 1998, the development of the credit derivatives market was hindered by the lack of standardization of legal docume
10、ntation.q Every trade (i.e., the buying and selling of a credit derivative contract) had to be customized.q In 1998, the International Swap and Derivatives Association (ISDA) developed a standard contract that could be used by parties to trades of a credit derivatives contract.q While the documentat
11、ion is primarily designed for credit default swaps and total return swaps, the contract form is sufficiently flexible so that it can be used for the other credit derivatives described in this chapter.ISDA Categorization (continued)q Reference Entity and Reference ObligationThe documentation will ide
12、ntify the reference entity and the reference obligation.The reference entity is the issuer of the debt instrument and hence also referred to as the reference issuer.It could be a corporation or a sovereign government.The reference obligation, also referred to as the reference asset, is the particula
13、r debt issue for which the credit protection is being sought.For example, a reference entity could be Ford Motor Credit Company.The reference obligation would be a specific Ford Motor Credit Company bond issue.ISDA Categorization (continued)q Credit EventsCredit default products have a payout that i
14、s contingent upon a credit event occurring.The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions”) provides a list of eight credit events:1.bankruptcy2.credit event upon merger3.cross acceleration4.cross default5.downgrade6.failure to pay7. repudiation / moratorium8.rest
15、ructuringThese eight events attempt to capture every type of situation that could cause the credit quality of the reference entity to deteriorate, or cause the value of the reference obligation to decline.ISDA Categorization (continued)qCredit EventsBankruptcy is defined as a variety of acts that ar
16、e associated with bankruptcy or insolvency laws.Failure to pay results when a reference entity fails to make one or more required payments when due.When a reference entity breaches a covenant, it has defaulted on its obligation.When a default occurs, the obligation becomes due and payable prior to t
17、he scheduled due date had the reference entity not defaulted.This is referred to as an obligation acceleration.A reference entity may disaffirm or challenge the validity of its obligation.This is a credit event that is covered by repudiation / moratorium.ISDA Categorization (continued)q Credit Event
18、sA restructuring occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms.The terms that can be changed would typically include, but are not limited to, one or more of the following:i.a reduction in the interest rateii
19、.a reduction in the principaliii. a rescheduling of the principal repayment schedule (e.g., lengthening the maturity of the obligation) or postponement of an interest paymentiv. a change in the level of seniority of the obligation in the reference entitys debt structureISDA Categorization (continued
20、)q Credit EventsThe Restructuring Supplement to the 1999 ISDA Credit Derivatives Definitions (the “Supplement Definition”) issued in April 2001 provided a modified definition for restructuring.There is a provision for the limitation on reference obligations in connection with restructuring of loans
21、made by the protection buyer to the borrower that is the obligor of the reference obligation. This provision requires the following in order to qualify for a restructuring:i.there must be four or more holders of the reference obligationii.there must be a consent to the restructuring of the reference
22、 obligation by a supermajority (66 2/3%)In addition, the supplement limits the maturity of reference obligations that are physically deliverable when restructuring results in a payout triggered by the protection buyer.ISDA Categorization (continued)q Credit EventsIn January 2003, the ISDA published
23、its revised credit events definitions in the 2003 ISDA Credit Derivative Definitions.The major change was to restructuring, whereby the ISDA allows parties to a given trade to select from among the following four definitions:i.no restructuringii.“full” or “old” restructuring, which is based on the 1
24、993 Definitionsiii. “modified restructuring,” which is based on the Supplement Definitioniv. “modified modified restructuring.”The last choice is new and was included to address issues that arose in the European market.Asset Swapsq When an investor possesses an asset and converts its cash flow chara
25、cteristics, the investor is said to have constructed an asset swap.q A common asset swap is for an investor to purchase a credit-risky bond with a fixed rate and convert it to a floating rate.q If the issuer of the bond defaults on the issue, the investor must continue to make payments to the counte
26、rparty of the interest-rate swap (i.e., the swap dealer) and is therefore still exposed to the credit risk of the issuer.Asset Swaps (continued) Lets now illustrate a basic asset swap. Suppose that an investor purchases $10 million par value of a 7.85%, five-year bond of a BBB-rated utility company
27、at par value. The coupon payments are semiannual. At the same time, the investor enters into a five-year interest-rate swap with a dealer where the investor is the fixed-rate payer and the payments are made semiannually. Suppose that the swap rate is 7.00% and the investor receives six-month LIBOR.
28、Lets look at the cash flow for the investor every six months for the next five years: Thus, regardless of how interest rates change, if the utility issuer does not default on the issue, the investor earns 85 basis points over six-month LIBOR.Received from utility bonds:7.85% Payment to dealer on swa
29、p:7.00%+ Payment from dealer on swap:6-month LIBORNet received by investor:0.85% + 6-month LIBORAsset Swaps (continued) Effectively, the investor has converted a fixed-rate BBB five-year bond into a five-year floating-rate bond with a spread over six-month LIBOR. Thus, the investor has created a syn
30、thetic floating-rate bond. The purpose of an asset swap is to do precisely that: create a synthetic credit-risky floating-rate security. While in our description of an asset swap the investor bought the credit-risky bond and entered into an interest-rate swap with a dealer, an asset swap typically c
31、ombines the sale of a credit-risky bond owned to a counterparty at par and with no interest accrued, with an interest-rate swap. This type of asset swap structure or package is referred to as a par asset swap. If there is a default by the issuer of the credit-risky bonds, the asset swap transaction
32、is terminated and the defaulted bonds are returned to the investor plus or minus any mark-to-market on the asset swap transaction. Hence the investor is still exposed to the issuers credit risk.Asset Swaps (continued)q The coupon on the bond in the par asset swap is paid in return for LIBOR, plus a
33、spread if necessary.q This spread is the asset swap spread and is the price of the asset swap.q In effect the asset swap allows investors that pay LIBOR-based funding to receive the asset swap spread.q This spread is a function of the credit risk of the underlying credit-risky bond.Asset Swaps (cont
34、inued) To illustrate this asset swap structure, suppose that in our previous illustration the swap rate prevailing in the market is 7.30% rather than 7.00%. The investor owns the utility bonds and sells them to a dealer at par with no accrued interest. The asset swap agreement between the dealer and
35、 the investor is as follows:The term is five years.The investor agrees to pay the dealer semiannually 7.30%. Lets look at the cash flow for the investor every six months for the next five years for this asset swap structure:Received from utility bonds:7.85% Payment to dealer on swap:7.30%+ Payment f
36、rom dealer on swap:6-month LIBOR + 30 basis pointsNet received by investor:0.85% + 6-month LIBORAsset Swaps (continued) In our first illustration of an asset swap, the investor is creating a synthetic floater without a dealer. The investor owns the bonds. The only involvement of the dealer is as a c
37、ounterparty to the interest-rate swap. In the second structure, the dealer is the counterparty to the asset swap structure and the dealer owns the underlying credit-risky bonds. If there is a default, the dealer returns the bonds to the investor. There are variations of the basic asset swap structur
38、e to remove unwanted non-credit structural features of the underlying credit-risky bond. The simplest example of an asset swap variation to remove an unwanted non-credit structural feature is when the bond is callable. If the bond is callable, then the future cash flows of the bond are uncertain bec
39、ause the issue can be called. Moreover, the issue is likely to be called if interest rates decline below the bonds coupon rate.Total Return Swapsq A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the t
40、otal return realized on a reference obligation or a basket of reference obligations.q When the reference obligation is a bond market index, the swap is referred to as a total return index swap.q The party that agrees to make the floating payments and receive the total return is referred to as the to
41、tal return receiver.q The party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.Total Return Swaps (continued)q There are variations of the basic asset swap structure to remove unwanted noncredit structural features of the underlying cre
42、dit-risky bond.q The simplest example of an asset swap variation to remove an unwanted non-credit structural feature is a callable bond.q In a swaption, an investor has the right to effectively terminate the swap from the time of the first call date for the bond to the maturity date of the bond.q Be
43、cause the investor is paying fixed and receiving floating, the swaption must be one in which the investor receives fixed and pays floating.q Credit-independent market risk is the risk that the general level of interest rates will change over the term of the swap.Total Return Swaps (continued)q Benef
44、its of Total SwapsThere are several benefits in using a total return swap as opposed to purchasing reference obligations themselves.i.The total return receiver does not have to finance the purchase of the reference assets. Instead, it pays a fee to the total return payer in return for receiving the
45、total return on the reference obligations.ii.The total return receiver can achieve the same economic exposure to a diversified basket of assets in one swap transaction that would otherwise take several cash market transactions to achieve.iii. Finally, an investor who wants to short the corporate bon
46、d will find it difficult to do so in the corporate bond market. An investor can do so efficiently by using a total return swap. In this case the investor will use a total return swap in which it is a total return payer and will receive a floating payment.Credit Default Swapsq The credit default swap
47、 is most popular type of credit derivative.q Its primary purpose is to hedge the credit exposure to a particular asset or issuer.q A credit default swap in which there is one reference obligation is called a single-name credit default swap.q When the reference obligation is a basket or portfolio of
48、obligations (e.g., 10 high-yield corporate bond of 10 different issuers), it is referred to as a basket credit default swap.q In a credit default swap, the protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit ev
49、ent by the reference obligation or the reference entity.q If a credit event occurs, then the protection seller must make a payment.Credit Default Swaps (continued)q Credit default swaps can be settled in cash or by physical delivery with the latter being more efficient.q If no credit event has occur
50、red by the maturity of the swap, both sides terminate the swap agreement and no further obligations are incurred.q The methods used to determine the amount of the payment obligated of the protection seller under the swap agreement can vary greatly.q A credit default swap can specify (at the contract
