Credit and Weather Derivatives

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Credit and Weather Derivatives

  1. 1. Credit and Weather Derivatives Liyan Dizon Marose Monedero Macky Villagarcia Feb 11, 2011
  2. 2. Credit Derivatives
  3. 3. What are credit derivatives? <ul><li>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 ). </li></ul><ul><li>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. </li></ul>
  4. 4. What are credit derivatives? <ul><li>These are derivative instruments that seek to trade in credit risks. </li></ul><ul><li>CREDIT RISK - The risk that a counterparty to a financial transaction will fail to fulfill their obligation </li></ul>
  5. 5. Growth in Credit Derivatives Source: British Bankers Association Credit Derivatives Report
  6. 6. Credit Derivatives Market Participants Source: British Bankers Association (BBA)
  7. 7. Types of Credit Derivatives <ul><li>Credit Default Swaps </li></ul><ul><li>Credit Spread Option </li></ul><ul><li>Credit Linked Note </li></ul>
  8. 8. 1. Credit Default Swap <ul><li>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). </li></ul><ul><li>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. </li></ul>
  9. 9. What is a credit event? <ul><li>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. </li></ul><ul><li>Credit events include bankruptcies or violating a bond indenture or other loan agreement. </li></ul>
  10. 10. Example… <ul><li>Suppose Bank A buys a bond which issued by a Steel Company. </li></ul><ul><li>To hedge the default of Steel Company, it enters into a credit derivative deal with Insurance Company C . </li></ul><ul><li>Bank A buys a credit default swap from Insurance Company C. </li></ul><ul><li>Bank A pays fixed periodic payments to C, in exchange for default protection. </li></ul>
  11. 11. Exhibit <ul><li>Credit Default Swap </li></ul>Bank A Buyer Insurance Company C Seller Steel company Reference Asset Contingent Payment On Credit Event Premium Fee Credit Risk
  12. 12. 2. Credit Spread Option <ul><li>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 </li></ul><ul><li>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 </li></ul>
  13. 13. Example… <ul><li>An investor may purchase from an insurer an option to sell a bond at a particular spread above LIBOR Credit spread. </li></ul><ul><li>If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse. </li></ul>
  14. 14. Example…
  15. 15. 3. Credit Linked Notes <ul><li>Is essentially a funded credit default swap which transfers credit risk from the note issuer to the investor. </li></ul><ul><li>The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral. </li></ul><ul><li>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. </li></ul>
  16. 16. Example… Refer to the Steel company case again <ul><li>Bank A would extend a $1 million loan to the Steel Company. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
  17. 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. 18. Weather Derivatives
  19. 19. Sources <ul><li>http://www.credit-deriv.com/introduction%20to%20credit%20derivatives%20article%20by%20Vinod%20Kothari.pdf </li></ul><ul><li>http://www.investopedia.com/terms/c/creditderivative.asp </li></ul>
  20. 20. Credit and Weather Derivatives Liyan Dizon Marose Monedero Macky Villagarcia Feb 11, 2011

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