13.2 credit linked notes

Copyright © 2018 CapitaLogic Limited
Chapter 13
Credit Linked Notes
This presentation file is prepared in accordance with
Chapter 13 of the text book
“Managing Credit Risk Under The Basel III Framework, 3rd ed”
Website : https://sites.google.com/site/crmbasel
E-mail : crmbasel@gmail.com

Copyright © 2018 CapitaLogic Limited 2
Declaration
 Copyright © 2018 CapitaLogic Limited.
 All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
 Authored by Dr. LAM Yat-fai (林日辉),
Director, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration,
CFA, CAIA, CAMS, FRM, PRM.

Outline
 Single name CLN
 Basket CLN
 Market value CLN

Single name CLN
 Investments in Tencent
 Any investor can invest in Tencent equities
 Only institutional investors can invest in Tencent bonds
 An investment bank, e.g. HSBC
 Purchases USD 1 mn principal of Tencent bonds
 Issues 1,000 notes, each with cash flows tracking the cash
flows of USD 1,000 principal of Tencent bonds
 Sells the notes to many individual investors and charges
commissions
 Individual investors subject to credit risk of both
Tencent and HSBC

Special purpose entity (SPE)
 A shell company
 Established by a financial institution, usually
incorporated in tax heaven, e.g. Cayman Island
 Bankruptcy remote
 Financially independent, not to be affected by the
credit quality of the parent financial institution
 Primary function
 To issue single name CLN

Single name CLN issued under SPE
 Establishes a SPE independent of HSBC
 Grants a short term loan to the SPE
 The SPE
 Purchases USD 1 mn principal of Tencent bonds
 Issues 1,000 notes, each with cash flows tracking the cash flows of
USD 1,000 principal of Tencent bonds
 Uses the proceeds from selling the notes to settle the short term loan
 HSBC, as an agent, charges commission on selling the notes
to many individual investors
 SPE, a liabilities free shell company, has no credit risk
 Individual investors subject to credit risk of Tencent only

Synthetic CLN
 Existing Tencent bonds may not match the LGD,
maturity, interest rate and interest payment days of
the requirements from investors
Reference debt + Single name CDS Risk-free security
Single name CLN + Single name CDS Risk-free security
Single name CLN - Single name CDS + Risk-free security




Synthetic CLN
SPE Investors
Top quality
assets
Premiums
Single name
CDS
Steady cash flows
Financial
institution
Single name
CLN

Synthetic CLN
 The SPE
 Issues to HSBC a single name CDS with USD 1 mn principal of hypothetical
Tencent bonds with LGD, maturity, interest rate and interest payment days
matching the requirements of investors
 Invests in USD 1 mn principal top quality assets (AAA)
 Issues 1,000 notes, each with cash flows tracking those of USD 1,000
principal of the hypothetical Tencent bonds
 HSBC, as an agent, charges commission on selling the notes to many
individual investors
 SPE, a liabilities free shell company, has no credit risk
 Individual investors subject to credit risk of Tencent only

Cash flows
 Cash outflow
 An initial amount to acquire a single name CLN
 Cash inflows
 Reference debt survives
 Scheduled interests and principal
 Reference debt defaults
 EAD × (1 - LGD)
Example 13.1

Valuation
Category Factor Impact to
value
Variation Impact to
credit risk
Reference
debt
Principal + No +
LGD - Moderate +
PD - Material +
RM -
Decreasing
gradually
+
CLN Interest rate + No +

Credit risk
 Equivalent to the reference debt
 
 
RM
RM
EL = EAD × LGD × 1 - 1 - PD
1-year EL = EAD × LGD × Min 1, 1 - 1 - PD
 
 
 
 

Outline
 Single name CLN
 Basket CLN

Yield enhancement
 One shared principal
 Reference to a basket of identical debts from
different issuers
 Track the cash flows of the 1TD reference
debt
 Higher credit risk => higher return

Basket CLN
 A basket of identical reference debts seldom exists
physically
 To synthesize with 1TD CDS
Basket CLN + 1TD CDS Risk-free security
Basket CLN - 1TD CDS + Risk-free security



Basket CLN
SPE Investors
Top quality
assets
Premiums
1TD CDS
Steady cash flows
Financial
institution
Basket CLN

Basket CLN
 The SPE
 Issue a 1TD CDS with USD 1 mn principal on three identical hypothetical
bonds issued by Tencent, Ping An Insurance and China Mobile
 Invests in USD 1 mn principal top quality assets (AAA)
 Issues 1,000 notes, each with cash flows tracking those of the 1TD reference
bonds
 HSBC, as an agent, charges commission on selling the notes to many
individual investors
 SPE has no credit risk
 Individual investors subject to credit risk of the 1TD reference bond

Cash flows
 Cash outflow
 An initial amount to acquire a basket CLN
 Cash inflows
 All reference debt survives
 Scheduled interests and principal
 One reference debt defaults
 EAD × (1 - LGD)
Example 13.2

Valuation
Category Factor Impact to
value
Variation Impact to
credit risk
Reference
debt
Principal + No +
LGD - Moderate +
PD - Material +
RM -
Decreasing
gradually
+
Basket
Basket size - No +
Default
dependency
+ Moderate -
CLN Interest rate + No +

Probability of first default
 Actual P1D
 Monte Carlo with over one million trials
 Lower bound of the P1D
 Maximum of the PDs of the reference debts
 Upper bound of the P1D
 Sum of all PDs
Example 13.4
Example 13.3

Credit risk
 General case
 EL or 1-year EL with Monte Carlo simulation
 Same LGD in addition to same EAD and RM
  
 
RM
RM
EL = EAD × LGD × 1 - 1 - P1D
1-year EL = EAD × LGD × Min P1D, 1 - 1 - P1D
 
 
 
 
Example 13.5

Outline
 Single name CLN
 Basket CLN

Market value CLN
SPE Investors
Top quality
assets
Premiums
Basket CDS
Steady cash flows
Financial
institution
Basket CLN
Active trading portfolio

Market value CLN
 Top quality assets
 Selling high
 Buying low
 Trading profit to offset part of default loss
 Risk
 Credit risk of reference debts
 Trading risk of top quality assets

13.2 credit linked notes

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13.2 credit linked notes