Introduction to credit derivatives

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Introduction to credit derivatives

Introduction to credit derivatives

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  • 1. Introduction To Credit Derivatives Stephen P. D’Arcy and Xinyan Zhao
  • 2. What are Credit Derivatives?
    • “ Credit derivatives are derivative instruments
    • that seek to trade in credit risks. ”
    • http://www.credit-eriv.com/meaning.htm
  • 3. What are Derivatives?
    • A financial contract that has its price derived from, and depending upon, the price of an underlying asset.
    • The underlying assets might be traded.
    • Types of Derivatives include, Swaps, Options and Futures for example.
  • 4. What is Credit Risk ?
    • The risk that a counterparty to a financial transaction will fail to fulfill their obligation.
  • 5. Growth in Credit Derivatives Source:BBA Credit Derivatives Report 2006
  • 6. Types of credit derivatives
    • – Credit default swap
    • – Credit spread option
    • – Credit linked note
  • 7. What is Credit default swap?
    • Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
    • The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."
  • 8. Example
    • Suppose Bank A buys a bond which issued by a Steel Company.
    • To hedge the default of Steel Company:
    • Bank A buys a credit default swap from Insurance Company C.
    • Bank A pays a fixed periodic payments to C, in exchange for default protection.
  • 9. Exhibit
    • Credit Default Swap
    Bank A Buyer Insurance Company C Seller Steel company Reference Asset Contingent Payment On Credit Event Premium Fee Credit Risk
  • 10. What is credit spread option?
    • A credit spread option grants the buyer the right, but
    • not the obligation, to purchase a bond during a
    • specified future “exercise” period at the
    • contemporaneous market price and to receive an
    • amount equal to the price implied by a “strike spread” stated in the contract.
  • 11. Credit Spread
    • The different between the yield on the borrower’s
    • debt (loan or bond) and the yield on the referenced
    • benchmark such as U. S. Treasury debt of the same
    • maturity.
  • 12. Example
    • An investor may purchase from an insurer an option
    • to sell a bond at a particular spread above LIBOR
    • Credit spread.
    • If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse.
  • 13. Exhibit Profit Spot price Strike price
  • 14. Credit-linked notes
    • A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the
    • note issuer to the investor.
    • The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.
    • If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.
  • 15. Example
    • Refer to the Steel company case again.
    • Bank A would extend a $1 million loan to the Steel Company.
    • At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.
    • If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.
  • 16. Exhibit Bank A Institutional investors Steel Company $1 Million fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate $1million 500b p Steel Company
  • 17. Credit Derivatives Market Participants Source:British Bankers Association (BBA) 2003/2004 Credit Derivatives Report
  • 18. For the protection buyer (the risk seller)
    • – to transfer credit risk on an entity without transferring the underlying instrument – regulatory benefit – reduction of specific concentrations portfolio management
    • – to go short credit risk
  • 19. Credit Derivatives Market Participants Source:British Bankers Association (BBA)
  • 20. For the protection seller (the risk buyer)
    • – diversification
    • – leveraged exposure to a particular credit
    • – access to an asset which may not
    • otherwise be available to the risk buyer
    • sourcing ability
    • – increase yield
  • 21. Questions
    • Does your bank use credit derivatives? If yes,
    • a. What type?
    • b. How long?
    • What is the primary purpose?
  • 22.
    • Do you think that most bankers in China understand credit derivatives? If not,
    • a. What could help them understand credit derivatives better?
    • b. What would be the most effective way to help?
  • 23.
    • Do you think banks in China should use credit derivatives to manage credit risk?
    • a. What problems need to be solved to improve risk management?
    • b. Do regulations need to be changed?