B contrast forward commitments with contingent claims Flashcards
contrast forward commitments with contingent claims
Forward Contract
agreement to trade an asset at a specific future time
Contingent Claim
Contingent: Depends on a random particular outcome Claim: provides the right but not the obligation to buy or sell an asset or CF.
- Contingency met? Yes. Then agent receives CF.
- associated with a right to make a final payment contingent on the performance of the underlying.
FWD Commitment v. Contingent Claim
FWD Commitments (Contracts, futures, swaps) Linear payoffs
Contingent Claims are primarily options
Options “transform the payoffs of the underlying into something quite different, as they limit losses in one direction”.
Differences (in contrast) between options and forward commitments
Price agreed upon is paid when contract is initiated, thus beginning price is 0
Buyer pays seller cash at start but has the right not obligation buy a call or sell a put. Options have a value at start as the premium paid by buyer to seller.
Contingent Claim (Credit Derivative)
a class of derivative contracts between credit protection buyer and credit protection seller, in which seller provides credit protection to buyer against a specific credit loss.”
Credit derivative buys and sells credit protection against specific credit loss.
First: total Return Swap: Underlying = bond or loan. Credit protection seller offers total return on underlying.
*TR bond: Interest + Principle +/- Int rate change.
Sells fixed or floating credit protection rate
Credit Spread (investors perception of credit risk) Option
Underlying = Yield spread on bond (bonds yield - yield on benchmark default free)
Buy strike spread and pay option premium.
Credit-Linked Note
Buyer holds a default prone bond but offers own securities. If bond=default, then principal repayment is dramatically reduced. Buyer ensures the credit risk of the underlying reference security.
Credit Default Swaps (CDS)
“A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.”
“collect periodic payments and are required to pay out if a loss occurs from the default of a third party”
“CDSs effectively provide coverage against a loss in return for the protection buyer paying a premium to the protection seller, thereby taking the form of insurance against credit loss”
Simply, payments made by one party in return for the promise of covering the losses of the other.
3rd party = borrower
Lender = CDS Buyer
Lender pays seller with borrowers % repayments and principal
“to understand and appreciate the importance of the CDS market, it is necessary to recognize how that market can fail.” “AIG and many other CDS sellers were thus highly exposed to systemic credit contagion, a situation in which defaults in one area of an economy ripple into another, accompanied by bank weaknesses and failures, rapidly falling equity markets, rising credit risk premiums, and a general loss of confidence in the financial system and the economy.”
“Credit derivatives provide a guarantee against loss caused by a third party’s default. They do not involve borrowing the premium or the payoff.”
ABS’s
Pmts tranched (thus preferential)
“When a portfolio of mortgages is assembled into an ABS, the resulting instrument is called a collateralized mortgage obligation (CMO).”
definition: “An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.”
CBOs, CLOs, CDOs
No prepayment risk
Yes credit risk
Senior, Mezzanine, Junior tranches ranked ordinal by credit quality.
Since contingent on prepayments and defaults, they’re options - cuz contingent claims.
“If something goes badly, the return can be lowered, and the worse the outcome, the lower the return. Thus, holders of ABSs have effectively written put options.”
