Credit Risk and Credit Derivatives

Question 1

1.Why is the market for fixed income securities other than riskless bonds often termed the spread product market?

Answer 1

• Because other U.S. dollar-denominated fixed income products, such as bank loans, high-yield bonds, investment-grade corporate bonds, or emerging markets debt, trade at yields containing a credit spread relative to U.S. Treasury securities.

Question 2

2.What are the three factors that determine the expected credit loss of a credit exposure?

Answer 2

• Probability of default (PD), which specifies the probability that the counterparty may fail to meet its obligations
• Exposure at default (EAD), which specifies the nominal value of the position that is exposed to default at the time of default
• Loss given default (LGD), which specifies the economic loss in case of default

Question 3

3. What is the relationship between the recovery rate and the loss given default?

Answer 3

• Loss given default (LGD) = (1-R), where R = the recovery rate

Question 4

4. List the two key characteristics that can make risk-neutral modeling a powerful tool for pricing
   financial derivatives.

Answer 4

• The risk-neutral modeling approach provides highly simplified and easily tractable modeling, and
• Often derivative prices generated by risk-neutral modeling must be the same as the prices in an
economy where investors are risk-averse.

Question 5

5. List the four stages in the evolution of credit derivative activity.

Answer 5

• The first, or defensive, stage, which started in the late 1980s was characterized by ad hoc attempts by banks to lay off some of their credit exposures. The second stage, which began about 1991 was the emergence of an intermediated market in which dealers applied derivatives technology to the transfer of credit risk and investors entered the market to seek exposure to credit risk. The third stage was maturing into resembling other forms of derivatives with major regulatory guidance. Dealers began warehousing risks and running hedged and diversified portfolios of credit derivatives. The fourth stage centered on the development of a liquid market.

Question 6

6.What is the primary difference between a total return swap on an asset with credit risk and a credit default swap on that same asset?

Answer 6

• In the case of a credit default swap, the credit protection buyer makes fixed payments, known as the swap premium, to the credit protection seller. In the case of a total return swap, the credit protection buyer makes payments to the credit protection seller based on the total market return of the underlying asset. The total market return is comprised of any coupon payments and any change in the underlying bond’s market price.

Question 7

7. List the seven kinds of potential trigger events in the standard ISDA agreement.

Answer 7

• Bankruptcy
• Failure to pay
• Restructuring
• Obligation acceleration
• Obligation default
• Repudiation/moratorium
• Government intervention.

Question 8

8. How can one party to a CDS terminate credit exposure (other than counterparty risk) to a CDS without the consent of the counterparty to the CDS?

Answer 8

• By entering an offsetting position, by assigning the contract to a dealer or other approved counterparty (with permission of the original counterparty, or by reaching an agreement with the original counterparty to mutually terminate the contract.

Question 9

9. If a speculator believes that the financial condition of XYZ Corporation will substantially deteriorate relative to expectations reflected in market prices, should the speculator purchase a credit call option on a spread or a price?

Answer 9

• Spread. Deterioration in credit increases credit spreads and lowers risky bond price.

Question 10

10. What CDS product should an investor consider when attempting to hedge the credit risk of a very
    large portfolio of credit risks rather than the hedge a few issues?

Answer 10

• CDS index products