Credit Risk and Credit Derivatives

Credit Derivatives

Credit derivatives are financial contracts designed to reduce or transfer credit risk exposure. A payout under a credit derivative is triggered by a credit event. Banks use CDs to transfer their credit risks and continue providing credits

Features of CDs
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Credit Derivative Instruments

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Protection buyer and protection seller Risk Premium Reference Asset Reference Entity Credit Event Cash/physical Settlement

Credit Default Swaps The Total Return Swap Credit Linked Note Asset Backed Securities Collateralized Debt Obligations

P K Mohanty, NIBM

Credit Default Swap (CDS)

n

Credit Default Swap

This is a bilateral contract in which a periodic fixed fee or premium is paid to a protection seller, in return for which the seller will make a payment on the occurrence of a specified credit event. Being structured, the CDS enables one party t o transfer its credit exposure to another party. The maturity of the default swap does not have to match with the maturity of reference asset.

Credit Default Swap

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Credit Default Swap

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Buyer pays a premium of 120 bps per year for $100 million of 5-year protection against company X Premium is known as the credit default spread. It is paid for life of contract or until default If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are deliverable, typically cheapest deliverable bond)

Payments are usually made quarterly in arrears In the event of default there is a final accrual payment by the buyer Settlement can be specified as delivery of the bonds or in cash Suppose payments are made quarterly in the example just considered. What are the cash flows if there is a default after 3 years and 1 month and recovery rate is 40%?

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Using a CDS to Hedge a Bond

Portfolio consisting of a 5-year par yield corporate bond that provides a yield of 6% and a long position in a 5-year CDS costing 100 basis points per year is (approximately) a long position in a riskless instrument paying 5% per year
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Total Rate of Return Swaps

The central concept is the replication of the total performance of a credit asset (either a bond or a loan). Total return of a bank loan or a credit sensitive security is exchanged for some other cash flows, usually tied to LIBOR. Total return may be defined as the sum of interest payment plus capital appreciation.

Total Return Swap

n

Credit Linked Notes (CLN)

A credit linked note is a security, usually issued by an investment grade entity, that has an interest payment and fixed maturity structure similar t o a bond. The performance of the note, however, is linked to the performance of specified underlying asset a s well a s that of the issuing entity. Essentially credit linked notes are hybrid instruments that combine a credit derivative with a bond.

P K Mohanty, NIBM

Credit Linked Note: An Example

Let us consider an issuer of credit cards that wants to fund its (credit card) loan portfolio via an issue of debt. In order t o reduce the credit risk of the loans, it issues a two-year credit linked notes. The principal amount of the bond is 100 percent as usual, and it pays a coupon of 7.50%, which is 200 bp above the two year benchmark. If however, the incidence of bad debt amongst credit card holders exceeds 10% then the term states that note holders will only receive back R s. 85 per R s. 100 nominal.
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The example continued

The credit card issuer has in effect purchased a credit option that lowers its liability in the event that it suffers from a specified credit event, which in this case is an above-expected incidence of bad debts. Investors may wish to purchase CLN because the coupon paid on it will be above what the credit card bank would pay on a bond and higher than other comparable investments in the market.

Credit Linked Notes (CLN)

n

Asset Backed Securities

Security created from a portfolio of loans, bonds, credit card receivables, mortgages, auto loans, music royalties, etc A waterfall defines how income is first used to pay the promised return to the senior tranche, then to the next most senior tranche, and so on.

P K Mohanty, NIBM

Possible Structure
Asset 1 Asset 2 Asset 3 Tranche 1 (equity) Principal=$5 million Yield = 30% Tranche 2 (mezzanine) Principal=$20 million Yield = 10% Tranche 3 (super senior) Principal=$75 million Yield = 6%

The Mezzanine Tranche is Most Difficult to Sell

The mezzanine tranche is repackaged with other similar mezzanine tranches

Subprime Mortgage Portfolio

Equity Tranche (5%) Not Rated

SPV

Equity Tranche (5%) Mezzanine Tranche (20%) BBB Mezzanine Tranche (15%) BBB Super Senior Tranche (75%) AAA Super Senior Tranche (80%) AAA

Asset n Principal=$100 million

Collateralized Debt Obligations

n

Synthetic CDO Structure

CDS 1 CDS 2 CDS 3
Tranche 1: 5% of principal Responsible for losses between 0% and 5% Earns 1500 bps Tranche 2: 10% of principal Responsible for losses between 5% and 15% Earns 200 bps Tranche 3: 10% of principal Responsible for losses between 15% and 25% Earns 40 bps Tranche 4: 75% of principal Responsible for losses between 25% and 75% Earns 10bps

A cash CDO is an ABS where the underlying assets are corporate debt issues A synthetic CDO involves forming a similar structure with short CDS contracts on the companies In a synthetic CDO most junior tranche bears losses first. After it has been wiped out, the second most junior tranche bears losses, and so on

6
CDS n Average Yield 8.5%

Trust

P K Mohanty, NIBM

Evolution of CDS: Global Growth (2001~2012)

Credit Default Swaps Outstanding in billion $
70,000.00

Breakdown of market participation

60,000.00

24% 42%

50,000.00

40,000.00

34%

30,000.00

20,000.00

10,000.00

Intermediary / Market Maker

1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 2H11 1H12

Buyer

Seller

Source: ISDA Market Survey (2001~10), DTCC (2010~12)

Source: ISDA Market Survey (2001~10), DTCC (2010~12)

Credit Derivatives by region

3%

Credit rating of underlying reference entity in CDS

AAA-AA
100% 90% 17% 80% 70% 11% 16% 30% 37%

A-BBB

BB or Below

39%

43%
60% 67% 50% 66% 40% 65%

59%

10%

5%
30% 20% 10% 22% 19% 10% 2004 2006 2008

52%

17%

11% 2010

London

Europe ex-London

Asia/Australia

US

Other

0 % 2002

Source: ISDA Market Survey (2001~10), DTCC (2010~12) Source: ISDA Market Survey (2001~10), DTCC (2010~12)

P K Mohanty, NIBM

Tenor distribution of CDS

Over 10 years 2% Under 1 year 7% 5 10 years 21%

Credit Derivatives in India

2 0 1 0 Internal Group report in Introduction of CDS released in July Detailed policy framework with discussion on international practices 2 0 1 1 Capital adequacy guidelines released in November First trade printed in December between ICICI and IDBI

2 0 0 3 1 s t Draft Guidelines Scope of allowing banks and financial institutions to use credit derivatives

5 years 18%

1 5 years 52%

2 0 0 7 2 nd Draft Guidelines To permit Banks and PDs to deal in singlename CDS. Kept in abeyance on account of global financial crisis

2 0 1 1 3 rd Draft Guidelines in Feb and Final Guidelines in May Final guidelines published to be effective from October

Source: ISDA Market Survey (2001~10), DTCC (2010~12)

Credit Derivatives in India

Market Makers

Commercial Banks Primary Dealers NBFCs# Mutual Funds* Insurance Companies*

Thank you!!!

Users

* Subject to permission from their respective regulators

#

Market Makers Housing Finance Companies Provident Funds Listed Companies FIIs

Currently only as Users

P K Mohanty, NIBM