Introduction to credit derivatives


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Introduction to credit derivatives

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Introduction to credit derivatives

  1. 1. Introduction To Credit Derivatives Stephen P. D’Arcy and Xinyan Zhao
  2. 2. What are Credit Derivatives? <ul><li>“ Credit derivatives are derivative instruments </li></ul><ul><li>that seek to trade in credit risks. ” </li></ul><ul><li> </li></ul>
  3. 3. What are Derivatives? <ul><li>A financial contract that has its price derived from, and depending upon, the price of an underlying asset. </li></ul><ul><li>The underlying assets might be traded. </li></ul><ul><li>Types of Derivatives include, Swaps, Options and Futures for example. </li></ul>
  4. 4. What is Credit Risk ? <ul><li>The risk that a counterparty to a financial transaction will fail to fulfill their obligation. </li></ul>
  5. 5. Growth in Credit Derivatives Source:BBA Credit Derivatives Report 2006
  6. 6. Types of credit derivatives <ul><li>– Credit default swap </li></ul><ul><li>– Credit spread option </li></ul><ul><li>– Credit linked note </li></ul>
  7. 7. What is Credit default swap? <ul><li>Credit default swaps allow one party to &quot;buy&quot; 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 &quot;buyer&quot; of protection pays a premium for the protection, and the &quot;seller&quot; of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified &quot;credit events.&quot; </li></ul>
  8. 8. 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: </li></ul><ul><li>Bank A buys a credit default swap from Insurance Company C. </li></ul><ul><li>Bank A pays a fixed periodic payments to C, in exchange for default protection. </li></ul>
  9. 9. 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
  10. 10. What is credit spread option? <ul><li>A credit spread option grants the buyer the right, but </li></ul><ul><li>not the obligation, to purchase a bond during a </li></ul><ul><li>specified future “exercise” period at the </li></ul><ul><li>contemporaneous market price and to receive an </li></ul><ul><li>amount equal to the price implied by a “strike spread” stated in the contract. </li></ul>
  11. 11. Credit Spread <ul><li>The different between the yield on the borrower’s </li></ul><ul><li>debt (loan or bond) and the yield on the referenced </li></ul><ul><li>benchmark such as U. S. Treasury debt of the same </li></ul><ul><li>maturity. </li></ul>
  12. 12. Example <ul><li>An investor may purchase from an insurer an option </li></ul><ul><li>to sell a bond at a particular spread above LIBOR </li></ul><ul><li>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>
  13. 13. Exhibit Profit Spot price Strike price
  14. 14. Credit-linked notes <ul><li>A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the </li></ul><ul><li>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>
  15. 15. Example <ul><li>Refer to the Steel company case again. </li></ul><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>
  16. 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. 17. Credit Derivatives Market Participants Source:British Bankers Association (BBA) 2003/2004 Credit Derivatives Report
  18. 18. For the protection buyer (the risk seller) <ul><li>– to transfer credit risk on an entity without transferring the underlying instrument – regulatory benefit – reduction of specific concentrations portfolio management </li></ul><ul><li>– to go short credit risk </li></ul>
  19. 19. Credit Derivatives Market Participants Source:British Bankers Association (BBA)
  20. 20. For the protection seller (the risk buyer) <ul><li>– diversification </li></ul><ul><li>– leveraged exposure to a particular credit </li></ul><ul><li>– access to an asset which may not </li></ul><ul><li>otherwise be available to the risk buyer </li></ul><ul><li>sourcing ability </li></ul><ul><li>– increase yield </li></ul>
  21. 21. Questions <ul><li>Does your bank use credit derivatives? If yes, </li></ul><ul><li>a. What type? </li></ul><ul><li>b. How long? </li></ul><ul><li>What is the primary purpose? </li></ul>
  22. 22. <ul><li>Do you think that most bankers in China understand credit derivatives? If not, </li></ul><ul><li>a. What could help them understand credit derivatives better? </li></ul><ul><li>b. What would be the most effective way to help? </li></ul>
  23. 23. <ul><li>Do you think banks in China should use credit derivatives to manage credit risk? </li></ul><ul><li>a. What problems need to be solved to improve risk management? </li></ul><ul><li>b. Do regulations need to be changed? </li></ul>