8 - credit derivatives Flashcards
What are credit derivatives?
Is the collective term for a number of types of derivative instrument for which the source of risk is credit
What is total return swap?
Where two counterparties swap performance risk of an underlying asset. The total return is paid one way (coupon ± changes in value)
in exchange for a set payment (e.g. LIBOR + x%).
If the underlying asset defaults, the asset is delivered in return for the
par value of the asset.
What does CDS stand for?
Credit Default Swap - an instrument that may be:
a) Single name
b) Multi-name (incl. index products)
What does CDO stand for?
Collateralised Debt Obligation - an instrument for which the underlying
risk is credit but there is collateral to back it e.g. mortgages/car loans etc
What are cash CDO?
These are backed by cash generating assets e.g.
mortgages or corporate bonds
What are synthetic CDO?
Created from portfolios of CDSs
Short investor speculates on the poor performance
of a reference securities. The short investor does
not need to own the securities!! Often referred to
therefore as Unfunded …
Long Investors sell protection at various tranches
of default of the underlying reference securities
Used as a means of speculation and arbitrage!
What are total return swaps? what are the 3 elements to a total return swap?
» Reference This is the underlying instrument the performance
Obligation of which is the subject of the “swap”.
» Total Return Passes the total return on the reference
Payer obligation to the Total Return Receiver
Creates a synthetic short position on the reference obligation.
» Total Return Pays an agreed cashflow (“premium”) to the Total Return
Receiver Payer in return for the total return of the reference
obligation.
The relationship between the Total Return Payer and the Reference Obligation
depends on the trading approach of the Total Return Payer:
» Hedging The Total Return Payer is hedging default risk on an underlying
obligation for an alternative cash flow. It eliminates the risk of ownership
whilst retaining some of the benefits e.g. voting rights
» Speculating The Total Return Payer doesn’t need to own the Reference
Obligation – they can be “naked short” and would only need to own the
obligation
Why would each of the Total Return Payer want to enter
such a swap agreement?
» Reduced The Total Return Payer will only lose its Principal if
Credit Risk both the Reference Obligation AND the Total
Return Receiver default. The swap may pay more
than similar highly rated instruments
» Lower Under Basel II capital adequacy regulations, the
Regulatory regulatory capital charge for credit risky assets was
Capital reduced by 80% if credit protection is bought from
a similarly regulated Financial Institution!
Why would each of the Total Return Receiver want to enter
such a swap agreement
» Reduced The Total Return Receiver takes a synthetic ‘Long’
Funding position – it does not have to raise capital. The
Cost Total Return Payer buys the asset (at its reduced
cost of capital) and the Total Return Receiver
‘leases’ it from them!
» Asset Class The Total Return Swap mechanism may provide a
Access smaller FI with ‘synthetic’ access to asset classes
that might otherwise be unavailable.
What are the three elements to credit default swaps?
» Reference This is the underlying obligation, the credit
Obligation performance of which is the subject of the “swap”.
» Protection Pays a periodic premium in exchange for payment
Buyer should a reference obligation Credit Event occur
» Protection Receives a periodic payment (“premium”) in
Seller exchange for a reference obligation Credit Event
occur.
The relationship between the Protection Buyer and the Protection
Seller depends on the trading approach of the Protection Buyer:
» Hedging The Protection Buyer is hedging default risk on an
underlying obligation. Protection of this sort is often
referred to as “insurance” (but it isn’t!).
» Speculating The Protection Buyer doesn’t need to own the
Reference Obligation – they can “synthetically”
buy protection and would only need to own the
obligation (if settlement upon default is based on
physical delivery)!!
What is ISDA?
The International Swaps and Derivatives Association Inc.
» Reduce counterparty credit risk
» Increasing transparency
» Improve the industry’s operational infrastructure
One of the most important functions it has performed is to define a standardised swap
agreement, and in particular to define what constitutes a Credit Event!
