corporate debt and credit derivatives

Question 1

various categories of corporate debt were –

Answer 1

debentures,
loan stock,
preference shares.

Question 2

In analysing corporate debt the key issue to be considered is, generally:

Answer 2

the security of the debt and

the risk of default.

Question 3

the use of credit derivatives has

Answer 3

significantly deepened the market for corporate debt.
Associated with this have been the study of credit risk
and the allowance for risk of default in pricing.

Question 4

use credit derivatives to

Answer 4

reduce their exposure to the risk of default.

Question 5

one method of pricing corporate debt and assessing credit risk

Answer 5

based on the information about the credit risk

of the debt contained within the company’s equity.

Question 6

Can Calculate expected default losses from bond prices :

Answer 6

a credit rating gives
an indication of the
creditworthiness of a bond.

Question 7

A typical categorisation system of credit rating – such as that used by Standard & Poor’s:

Answer 7

Assignsa 
grade of AAA to the most creditworthy bonds, 
which are deemed to have 
almost no chance of defaulting. 
AA is then the next best rating, 
then A, 
then BBB, 
then BB and so on.

Question 8

Fundamental analysis of bonds entails

Answer 8

The process of credit rating

Question 9

Zero-coupon yield curves are derived by

Answer 9

a process called bootstrapping – .

Question 10

ZC Yield curves can be used to:

Answer 10

value other bonds.

Question 11

Example of Bond risk

Answer 11

Historical evidence suggests that 
the average probability of default
within the next 5 years
by a corporate bond currently rated AAA by Standard & Poor’s is about 0.1%,
whereas for a bond rated BBB the corresponding probability is over 2%.
margin over risk-free rate
(% pa)

Question 12

The higher yield on corporate bonds is entirely due to :

Answer 12

compensation for the additional risk

from investing in these instruments.

Question 13

It is generally accepted that there are two primary additional risks associated with Corporate Bonds:

Answer 13

1. Default risk –
   ⁃ which is the risk that the issuer
   ⁃ will not be in a position to make payment
   ⁃ of the interest or redemption payments,
   ⁃ either on the due dates or at all. 

2. Liquidity risk (strictly marketability risk) –
   ⁃ which is the risk that a holder of the bond will not be able
   ⁃ to realise value for it
   ⁃ in certain market conditions.
   ⁃ This might be because
   ⁃ the bond has certain unusual terms or covenants,
   ⁃ or because the issue is small
   ⁃ and unlikely to be attractive to major investors. 

   ⁃

Default and liquidity risk are not necessarily independent.

For example
if a company is in financial difficulties,
not only may it be more likely to default on debt interest payments,
but the debt may also be less marketable.

Also
market liquidity tends to be less
at times of economic distress
when overall defaults will tend to be higher.

Question 14

Corporate bonds typically

Answer 14

yield more than comparable Treasury bonds.

Question 15

Bond traders construct

Answer 15

zero-coupon yield curves 
for bonds of different credit rating categories and 
by comparing these 
to comparable Treasury curves 
we can see the magnitude of 
this excess credit spread 
for different maturities.

Question 16

The credit spread typically is

Answer 16

significantly in excess of historic default losses,
so that an investor could expect significantly higher returns
from investing in corporate bonds
than from investing in Treasury bonds.

Question 17

Actual default losses can be calculated

Answer 17

using historical data.

Question 18

The excess of the yield on corporate bonds over Treasury bonds is typically 
decomposed into four components:

Answer 18

1. Compensation for
   ⁃ expected defaults. 

2. Investors may expect
   ⁃ future defaults to exceed historic levels. 

3. Compensation for
   ⁃ the risk of higher defaults, ie
   ⁃ a credit risk premium. 

4. A residual that includes
   ⁃ the compensation for the liquidity risk —
   ⁃ typically referred to as an illiquidity premium.

Techniques being considered include :

1. the use of option pricing models using equity volatility
   ⁃ to estimate the risk of default (see Chapter 12), and
2. the use of credit default swaps (see Section 2.4 below)
   ⁃ to estimate the market premium for credit risk.

Question 19

Credit derivatives are

Answer 19

contracts 
where the payoff depends partly upon 
.the creditworthiness of 
one (or more) 
commercial (or sovereign) 
bond issuers.

Question 20

Credit derivatives are used for

Answer 20

managing credit risk

Question 21

The two most common types of credit derivative are:

Answer 21

1. credit default swaps 

2. credit spread options.

third also :
.credit-linked notes in the discussion that follows.

Question 22

Why is part of the higher yield on corporate bonds compensation for the risk of higher defaults over and above that indicated from historical data?

Answer 22

because bond investors are typically risk-averse.
So they will demand higher returns
from riskier bonds
even after allowing for the expected default losses
because of the greater uncertainty
regarding the returns provided.

Question 23

A credit default swap is

Answer 23

a contract 
that provides a payment 
if a particular event occurs. 
For example, 
it may give Bank X 
the right to sell a bond 
issued by utility Company Y 
to Bank Z 
for the face value of the bond 
should Company Y default on the bond. 
The bond involved is sometimes referred to as 
the reference bond.

Question 24

Credit events are

Answer 24

Events that trigger payments under credit derivatives

Question 25

Examples of credit events include:

Answer 25

  bankruptcy ( 1. insolvency, 2. winding-up, 3. appointment of a receiver) 
   a rating downgrade 
   cross-default. 1. A cross-default clause on a bond means 2. that a credit event on another security of the issuing firm 3. will also be considered as a credit event on the bond in question. 4. In addition, it is important to note that 5. default does not necessarily mean that all the money loaned is lost. 6. usually possible to recover (eventually) at least some of the money loaned, 7. the proportion recovered being referred to as the recovery.

Question 26

Buying a Credit Default swap

Answer 26

The party that buys the protection pays a fee to the party that sells the protection. If the credit event occurs within the term of the contract a payment is made from the seller to the buyer. If the credit event does not occur within the term of the contract, the buyer receives no monetary payment but has benefited from the protection during the tenure of the contract. So, in the example above, Bank X would pay a fee to Bank Z, typically in the form of a regular premium over the term of the swap. By doing so, it would effectively be purchasing insurance against the risk of the bond defaulting.

Question 27

two ways to settle a claim under a credit default swap:

Answer 27

A pure cash payment, representing the fall in the market price of the defaulted security. However, the market value may be difficult to determine. 
 Or ``` two: The exchange of both cash and a security (physical settlement). The protection seller pays the buyer the full notional amount and receives, in return, the defaulted security. ```

Question 28

In practice, CDS settlement is often based on

Answer 28

the difference between the face value of the bond and the value of the recovery, R. So, in the first case, a cash payment based on 100 - R would be made, whereas in the second case, the bond (now worth R) would be handed over and a cash payment of 100 made the net payment to the buyer of protection in the event of default is based on 100 - R .

Question 29

Banks and CDSs

Answer 29

Banks have historically been the largest users of credit default swaps, although institutional investors have become significant participants in the market.

Question 30

Using CDSs to Maintain credit relationships with a client

Answer 30

Lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship with that client can use credit default swaps to reduce their aggregate exposure to the client. Given the relationship need, the main users of credit default swaps are banks.

Question 31

Institutional investors use credit default swaps to

Answer 31

increase or reduce their credit exposure | to the underlying bond issuers.

Question 32


A credit-linked note consists of

Answer 32

a basic security | plus an embedded credit default swap.

Question 33

credit-linked notes provide

Answer 33

a useful way of stripping and repackaging credit risk. They consist of a credit default swap (which has already been discussed) embedded within a traditional bond.

Question 34

A credit spread option is

Answer 34

an option on the spread between the yields earned on two assets, which provides a payoff when the spread exceeds some level (the strike spread). The payoff could be calculated as the difference between the value of the bond with the strike spread and the market value of the bond.

Question 35

a credit spread option will typically specify

Answer 35

a strike date. will have a strike spread, of say 1%. Thus, a simple credit spread option might give the holder the option to sell a corporate bond on the strike date and at a price corresponding to the specified spread of 1% above the corresponding government bond yield. If the actual spread on the exercise date turns out to be 1.25% (ie the bond’s price has fallen relative to the corresponding government bond, presumably due to a worsening of its credit quality), then the holder will exercise the option, as he can sell the bond at a price above the current market price. Conversely, if the spread turns out to be less than 0.9% (ie the bond is dear), he will not do so as he can sell it at a higher price in the market. A credit spread option therefore provides protection against a widening of credit spreads.