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Structured Products Credit Derivatives Copyright © 1998-2006 Investment Analytics
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 1
Credit Derivatives Credit Risk ¾ Credit Assets ¾ Credit Derivatives ¾ Applications ¾
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 2
Credit Risk ¾
Default Risk
• Loan not repaid in full ¾
Downgrade Risk
• Rating agency reduces debtor’s credit rating • Reduces value of debt ¾
Credit Spread Risk
• If credit deteriorates, spread relative to base index will widen Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 3
Credit Risk Future bond cash flows not certain - risk of default ¾ Risk measured by rating agencies ¾
• Moody’s Investor Services • Standard & Poor’s Corp. ¾
Rating Scales: Moody’s Aaa Aa A Baa Ba - D
S&P AAA AA A BBB BB - D
Copyright © 1998-2006 Investment Analytics
Highest quality debt.
Min. investment grade High Yield (“Junk”)
Credit Derivatives
Slide: 4
Credit as an Asset ¾ Portfolio
of Credits can be segregated into baskets of loans ¾ Portfolio manager uses credit derivatives to: • enhance yields • diversify credit holdings
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 5
Rationale for Credit Derivatives: Credit Risk and Cost of Capital • Spread compensates for expected and unexpected loss • Spread should fund the loan loss reserve and provide adequate return on capital/reserve
Frequency of Occurence
expected loss = probability of default x (1 - recovery rate)
unexpected loss = volatility x (1 - recovery rate)
Loss ($mm)
3 standard deviations of loss
500
50
Spread = (1 - recovery rate)[expected default rate + return on capital] Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 6
Rationale for Credit Derivatives: Risk Adjusted Return 130
¾
Growing exposure demands increased spread to satisfy return on risk requirement Analysis helps identify credit constraints and opportunities
120 110 100 Spread (bp)
¾
Decrease exposure
Constant return on risk
90 80
Market spread
70 60
Increase exposure
50 0.1
0.5
1
2
5
10
Exposure (%)
¾
Active management of credit portfolio is key
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 7
Dynamic Management of Credit Risk
Exposure or Risk
Tolerance Level
Sell Credit Derivative or Loan Time
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 8
Rationale for Credit Derivatives ¾
Continuing and growing need for funding
¾
Managing reserve requirements & other constraints
¾
Enhancing credit characteristics of existing products & portfolios
¾
Pricing credit risk
¾
Credit risk and cost of capital
¾
Risk adjusted return
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 9
Applications ¾
Credit risk = default risk + credit spread risk
¾
Credit derivatives allow transfer of:
• Default Risk • Credit Spread Risk ¾
Reasons:
• Risk mitigation • Investment • Diversification Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 10
Asset management examples ¾
Hedging
• Transfer default risk in a confidential manner • Investor can short in new markets ¾
Replacement of cash assets
• Leverages return vs cash investment • Rescue structures ¾
Tax/accounting management
• Can defer/eliminate capital gains and withholding taxes Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 11
Defining credit derivatives ¾
Financial contracts with a payout linked to:
• • • •
Loan or bond values Default or credit events Credit spreads Credit ratings
¾
Cash settled, or delivery of underlying
¾
On single names, baskets, indices
¾
Delivery as notes or OTC contracts
¾
Delivery as swaps or options
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 12
Basic structures ¾
First generation
• Total return swap • Default swap • Default digital ¾
Second generation
• Floating rate asset derivatives • Fixed coupon asset derivatives • Rating option ¾
Third generation exotics
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 13
Total Return Swap • Party A pays total return on underlying asset • •
(including interest and capital appreciation) Party B pays funding payment (LIBOR + x%) plus any capital depreciation Bank A removes credit risk without selling the underlying Total Return B
A LIBOR + x% + any capital depreciation Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 14
Default Swap • Bank A pays default premium x b.p. until default • Bank B pays agreed notional amount on default • •
(relative to underlying reference loan or security) B assumes credit risk from A Bank A can factor cost of the swap into loan loan and removes credit risk of a valued customer X b.p. up to default B
A $Y on default Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 15
Limited Recourse Note This is a bond whose coupons are linked to defaultable underlying assets S1 and S2 ¾ Coupon is contingent: ¾
• X1% until default of S1 or S2 • X2% after first default • X3% after 2nd default
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 16
Credit Spread Option • Pays N[S-K]+ at maturity where
S is the yield spread between the underlying security and US Treasury K is an agreed strike level, N is notional.
• This is a straight play on movement of credit spreads.
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 17
Credit Swaps: Applications ¾
Single risk transfer
• transfer exposure to single credit ¾
Dual risk transfer
• exchange of pair of credits Yield enhancement ¾ Gaining market exposure ¾
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 18
Credit Swap: Single Risk Transfer Hedge default risk ¾ Diversify portfolio ¾
LIBOR + 20bp Bank
Portfolio Manager Leveraged Co. debt payments
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 19
Using Credit Swaps to Gain Exposure ¾
Fund wants high yield investment
• Emerging markets
¾
Problem: investment restrictions
• Typical: can’t invest below BBB grade debt Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 20
Emerging Market Credit Swap Example
Fixed coupon 7% Bank
Portfolio Manager Korean loan yield 8.25%
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 21
Credit Leverage ¾ Set
NP to desired leverage level
• Previous example: 125 bp spread on $1MM •
portfolio Set swap NP to $10MM: spread is now worth 12.5%
• If credit deteriorates loss is also greater!!
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 22
Credit Options Allow trading or hedging of changes in credit quality ¾ Put options ¾
• Right to sell credit (spread) at specified strike price ¾
Call options
• Right to purchase credit (spread) at specified strike price ¾
Typically achieved by purchasing bond options
• Put option on bond = call option on yield spread Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 23
Credit Option - Example ¾
Portfolio manager holds LDC debt
• Wants protection against falling credit values ¾
Purchases put option on Argentinian govt. bond
• Bond has 5 year term, duration 3.2 • Strike price, X = 100 bp spread • Premium = 75bp Later: spread widens to S = 128 ¾ Option payoff: Duration x (S - X) ¾
• 3.2 x (128 - 100) = 89.6 bp • Net gain: ~ 14.6bp Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 24
Exotic Credit Options Barrier and digital options common ¾ Example: ¾
• Portfolio manager bullish on Mexican debt • Seeks to profit from narrowing credit spread • Purchases up-and-out put on credit spread
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 25
Up and Out Credit Put 3.5
Strike = Floating + 30
3.0 2.5 2.0 1.5 1.0 0.5
Credit Spread
0.0 0
10
20
30
40
50
60
barrier = 40 bp
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 26
Other Credit Derivatives ¾
Credit spread caps
• Locks in maximum spread on borrowings ¾
Asset backed notes
• Bundle of non-investment grade credits ¾
Principal protected notes
• Offer up to 100% protection of principal ¾
Basket instruments
• Hard to price ¾
Credit index instruments
• Not yet widely traded Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 27
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 1
Credit Derivatives Credit Risk ¾ Credit Assets ¾ Credit Derivatives ¾ Applications ¾
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 2
Credit Risk ¾
Default Risk
• Loan not repaid in full ¾
Downgrade Risk
• Rating agency reduces debtor’s credit rating • Reduces value of debt ¾
Credit Spread Risk
• If credit deteriorates, spread relative to base index will widen Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 3
Credit Risk Future bond cash flows not certain - risk of default ¾ Risk measured by rating agencies ¾
• Moody’s Investor Services • Standard & Poor’s Corp. ¾
Rating Scales: Moody’s Aaa Aa A Baa Ba - D
S&P AAA AA A BBB BB - D
Copyright © 1998-2006 Investment Analytics
Highest quality debt.
Min. investment grade High Yield (“Junk”)
Credit Derivatives
Slide: 4
Credit as an Asset ¾ Portfolio
of Credits can be segregated into baskets of loans ¾ Portfolio manager uses credit derivatives to: • enhance yields • diversify credit holdings
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 5
Rationale for Credit Derivatives: Credit Risk and Cost of Capital • Spread compensates for expected and unexpected loss • Spread should fund the loan loss reserve and provide adequate return on capital/reserve
Frequency of Occurence
expected loss = probability of default x (1 - recovery rate)
unexpected loss = volatility x (1 - recovery rate)
Loss ($mm)
3 standard deviations of loss
500
50
Spread = (1 - recovery rate)[expected default rate + return on capital] Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 6
Rationale for Credit Derivatives: Risk Adjusted Return 130
¾
Growing exposure demands increased spread to satisfy return on risk requirement Analysis helps identify credit constraints and opportunities
120 110 100 Spread (bp)
¾
Decrease exposure
Constant return on risk
90 80
Market spread
70 60
Increase exposure
50 0.1
0.5
1
2
5
10
Exposure (%)
¾
Active management of credit portfolio is key
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 7
Dynamic Management of Credit Risk
Exposure or Risk
Tolerance Level
Sell Credit Derivative or Loan Time
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 8
Rationale for Credit Derivatives ¾
Continuing and growing need for funding
¾
Managing reserve requirements & other constraints
¾
Enhancing credit characteristics of existing products & portfolios
¾
Pricing credit risk
¾
Credit risk and cost of capital
¾
Risk adjusted return
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 9
Applications ¾
Credit risk = default risk + credit spread risk
¾
Credit derivatives allow transfer of:
• Default Risk • Credit Spread Risk ¾
Reasons:
• Risk mitigation • Investment • Diversification Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 10
Asset management examples ¾
Hedging
• Transfer default risk in a confidential manner • Investor can short in new markets ¾
Replacement of cash assets
• Leverages return vs cash investment • Rescue structures ¾
Tax/accounting management
• Can defer/eliminate capital gains and withholding taxes Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 11
Defining credit derivatives ¾
Financial contracts with a payout linked to:
• • • •
Loan or bond values Default or credit events Credit spreads Credit ratings
¾
Cash settled, or delivery of underlying
¾
On single names, baskets, indices
¾
Delivery as notes or OTC contracts
¾
Delivery as swaps or options
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 12
Basic structures ¾
First generation
• Total return swap • Default swap • Default digital ¾
Second generation
• Floating rate asset derivatives • Fixed coupon asset derivatives • Rating option ¾
Third generation exotics
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 13
Total Return Swap • Party A pays total return on underlying asset • •
(including interest and capital appreciation) Party B pays funding payment (LIBOR + x%) plus any capital depreciation Bank A removes credit risk without selling the underlying Total Return B
A LIBOR + x% + any capital depreciation Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 14
Default Swap • Bank A pays default premium x b.p. until default • Bank B pays agreed notional amount on default • •
(relative to underlying reference loan or security) B assumes credit risk from A Bank A can factor cost of the swap into loan loan and removes credit risk of a valued customer X b.p. up to default B
A $Y on default Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 15
Limited Recourse Note This is a bond whose coupons are linked to defaultable underlying assets S1 and S2 ¾ Coupon is contingent: ¾
• X1% until default of S1 or S2 • X2% after first default • X3% after 2nd default
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 16
Credit Spread Option • Pays N[S-K]+ at maturity where
S is the yield spread between the underlying security and US Treasury K is an agreed strike level, N is notional.
• This is a straight play on movement of credit spreads.
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 17
Credit Swaps: Applications ¾
Single risk transfer
• transfer exposure to single credit ¾
Dual risk transfer
• exchange of pair of credits Yield enhancement ¾ Gaining market exposure ¾
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 18
Credit Swap: Single Risk Transfer Hedge default risk ¾ Diversify portfolio ¾
LIBOR + 20bp Bank
Portfolio Manager Leveraged Co. debt payments
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 19
Using Credit Swaps to Gain Exposure ¾
Fund wants high yield investment
• Emerging markets
¾
Problem: investment restrictions
• Typical: can’t invest below BBB grade debt Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 20
Emerging Market Credit Swap Example
Fixed coupon 7% Bank
Portfolio Manager Korean loan yield 8.25%
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 21
Credit Leverage ¾ Set
NP to desired leverage level
• Previous example: 125 bp spread on $1MM •
portfolio Set swap NP to $10MM: spread is now worth 12.5%
• If credit deteriorates loss is also greater!!
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 22
Credit Options Allow trading or hedging of changes in credit quality ¾ Put options ¾
• Right to sell credit (spread) at specified strike price ¾
Call options
• Right to purchase credit (spread) at specified strike price ¾
Typically achieved by purchasing bond options
• Put option on bond = call option on yield spread Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 23
Credit Option - Example ¾
Portfolio manager holds LDC debt
• Wants protection against falling credit values ¾
Purchases put option on Argentinian govt. bond
• Bond has 5 year term, duration 3.2 • Strike price, X = 100 bp spread • Premium = 75bp Later: spread widens to S = 128 ¾ Option payoff: Duration x (S - X) ¾
• 3.2 x (128 - 100) = 89.6 bp • Net gain: ~ 14.6bp Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 24
Exotic Credit Options Barrier and digital options common ¾ Example: ¾
• Portfolio manager bullish on Mexican debt • Seeks to profit from narrowing credit spread • Purchases up-and-out put on credit spread
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 25
Up and Out Credit Put 3.5
Strike = Floating + 30
3.0 2.5 2.0 1.5 1.0 0.5
Credit Spread
0.0 0
10
20
30
40
50
60
barrier = 40 bp
Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 26
Other Credit Derivatives ¾
Credit spread caps
• Locks in maximum spread on borrowings ¾
Asset backed notes
• Bundle of non-investment grade credits ¾
Principal protected notes
• Offer up to 100% protection of principal ¾
Basket instruments
• Hard to price ¾
Credit index instruments
• Not yet widely traded Copyright © 1998-2006 Investment Analytics
Credit Derivatives
Slide: 27
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