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Credit and Weather Derivatives

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  • 1. Credit and Weather Derivatives Liyan Dizon Marose Monedero Macky Villagarcia Feb 11, 2011
  • 2. Credit Derivatives
  • 3. What are credit derivatives?
    • General term used to describe various swap and option contracts designed to transfer credit risk on loans or other assets from one party ( protection buyer ), to another party ( protection seller ).
    • The protection seller receives premium or interest-related payments in return for contracting to make payments to the protection buyers , which are linked to the credit standing of a reference asset.
  • 4. What are credit derivatives?
    • These are derivative instruments that seek to trade in credit risks.
    • CREDIT RISK - The risk that a counterparty to a financial transaction will fail to fulfill their obligation
  • 5. Growth in Credit Derivatives Source: British Bankers Association Credit Derivatives Report
  • 6. Credit Derivatives Market Participants Source: British Bankers Association (BBA)
  • 7. Types of Credit Derivatives
    • Credit Default Swaps
    • Credit Spread Option
    • Credit Linked Note
  • 8. 1. Credit Default Swap
    • 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 protection buyer pays a premium for the protection, and the protection seller agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified credit events.
  • 9. What is a credit event?
    • Any sudden and tangible (negative) change in a borrower's credit standing or decline in credit rating. A credit event brings into question the borrower's ability to repay its debt.
    • Credit events include bankruptcies or violating a bond indenture or other loan agreement.
  • 10. Example…
    • Suppose Bank A buys a bond which issued by a Steel Company.
    • To hedge the default of Steel Company, it enters into a credit derivative deal with Insurance Company C .
    • Bank A buys a credit default swap from Insurance Company C.
    • Bank A pays fixed periodic payments to C, in exchange for default protection.
  • 11. Exhibit
    • Credit Default Swap
    Bank A Buyer Insurance Company C Seller Steel company Reference Asset Contingent Payment On Credit Event Premium Fee Credit Risk
  • 12. 2. 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
    • CREDIT SPREAD – the difference between the yield on the borrower’s debt (loan or bond) and the yield on the referenced benchmark of the same maturity
  • 13. 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.
  • 14. Example…
  • 15. 3. Credit Linked Notes
    • Is essentially a funded credit default swap 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.
  • 16. 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.
  • 17. 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
  • 18. Weather Derivatives
  • 19. Sources
    • http://www.credit-deriv.com/introduction%20to%20credit%20derivatives%20article%20by%20Vinod%20Kothari.pdf
    • http://www.investopedia.com/terms/c/creditderivative.asp
  • 20. Credit and Weather Derivatives Liyan Dizon Marose Monedero Macky Villagarcia Feb 11, 2011