L16 - Credit Derivatives Flashcards

1
Q

What are Credit Default Swaps?

A
  • Credit Default Swaps (CDS) emerged in the 1990s and the market grew steadily and then spectacularly until the financial crisis erupted in 2007. (Their use increased almost tenfold in the three years prior to the financial crisis.)
  • Before the financial crisis of 2007, there was more money invested in credit default swaps than in other pools e.g. stock or bond markets. The value of credit default swaps stood at $45 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in U.S. Treasury Bonds.
  • The size of the market and the role Credit Default Swaps (CDS) played in the financial crisis made them a target for reform and since 2009, their use has declined as spectacularly as it once grew.
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2
Q

Why were credit derivatives developed?

A

A major risk faced by financial intermediaries is credit risk, that is, the risk that a borrower will default. Credit risk is therefore important to banks, bond issuers and bond investors. Credit derivatives were developed to provide insurance to all of these parties.

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3
Q

what is credit risk?

A

Credit risk is the probability that a borrower will default on a commitment to repay debt or bank loans. Default occurs when the borrower cannot fulfil key financial obligations, such as making interest payments to bondholders or repaying bank loans.

The probability is not fixed, during a boom, it is lower and during a recession, it is higher

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4
Q

How is a firm’s credit risk measured?

A
  • One way to measure a firm’s credit risk is through its credit rating. Rating agencies such as Moody’s Standard and Poor’s and Fitch specialise in performing this role.
  • A firm’s credit rating is largely based on an analysis of its financial statements. The highest credit rating for firms least likely to default is AAA (Aaa), and the lowest credit rating for firms most likely to default is CCC (Ccc) and below.
  • A more quantitative measure of credit risk is a firm’s credit risk premium, that is the difference between the interest rate a firm pays when it borrows and the interest rate on default-free security.
  • Credit ratings are important and a downgrade in a company’s credit rating can significantly increase its borrowing costs.
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5
Q

How are bond issuers and investors affected by credit risk?

A

Bond issuers are affected by credit risk because their cost of borrowing depends crucially on their risk of default.

Investors in individual bonds are exposed to the risk of a decline in the bond’s credit rating.

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6
Q

Why is the credit risk faced by banks high?

A

Banks are exposed to the risk that borrowers will default on their loans. The credit risk faced by banks is relatively high for two reasons

  1. The concentration of loans geographically.
    1. Tend to focus on specific industries, means they can be affected by industry-specific changes
  2. Credit risk is the predominant risk in loans made to businesses
    1. Because they make big loans there is a limit to how much they can diversify their portfolio
    2. interest rates adjust on a loan based on the state of the economy or the assessment of a companies
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7
Q

How can securitisation be used to manage credit risk?

A

A variety of methods are available to manage credit risk and traditional method have a focused on:

  • diversification
  • duration gap matching –> matching the timing of cash inflow and cash outflows

This changed when credit derivatives were developed allowing for risk to be passed on and moved off the bank’s balance sheet

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8
Q

Before the implementation of credit derivatives, what were securitisation only loans like?

A

In the early days of securitisation only loans that had standardised payment schedules and similar credit risk characteristics, such as home mortgages and car loans, were securitised.

  • As the benefits of securitisation became apparent securitised loans were used on corporate properties too
  • Now the application of securitisation are diverse with a wide range of different credit risks –> that are not subject to standard models of mismanagement or the standard approaches
  • due to the diverse range of borrowers, the credit derivatives were created - provided the insurance financial institutions needed in this new environment
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9
Q

What was the primary reason for the creation of credit derivatives?

A
  • to provide the financial institution with insurance against the risk new borrowers brought in from a diverse pool of securitised loans
  • credit derivatives are simply financial contracts that provide insurance against credit-related losses –> its firm-specific insurance
  • The arrangement is like an insurance policy. However, it is important to be aware that the credit risk in the bond has been separated from the bond.
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10
Q

How are credit derivatives different from actual insurance policies?

A
  • it is important to be aware that the credit risk in the bond has been separated from the bond.
  • One major difference is that the seller might not be a regulated entity (though in practice most are banks).
    • They can just decide the take on the risk as they are not subject to the tight regulations
  • The seller is not required to maintain reserves to cover the protection sold.
  • Insurance requires the buyer to disclose all known risks (e.g. health insurance need to know if you play a dangerous sport which allows them to put in clauses to protect themselves), while CDS do not.
  • The sellers of CDS can, in many cases, still determine potential risk ,as the debt instrument being ‘insured’ is a market commodity available for inspection but in the case f certain instruments like CDO’s made up of slices of debt packages, it can be difficult to tell exactly what is being insured
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11
Q

How do insurers manage risks?

A
  • Insurers manage risk primarily by setting loss reserves based on the Law of large numbers and actuarial analysis.
    • Dealers in CDS manage risk primarily by means of hedging with other CDS deals and in the underlying bond markets;
    • CDS contracts are generally subject to mark-to-market accounting introducing income statement and balance sheet volatility while insurance contracts are not
  • To cancel the insurance contract the buyer can typically stop paying premiums
    • With CDS you pay regular premiums but you cannot get out of them so easily - they need to be unwound
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12
Q

How big is the Credit Derivative market?

A

Credit derivatives were once VERY big business. They still are ‘very big’ business, but the market is now nowhere near as big as it once was. To give some idea, the market for credit derivatives exceeded $60 trillion of notional principal in 2007.

A credit default swap (or a credit default option) is the simplest credit derivative instrument.

Here the buyer of the instrument acquires protection from the seller against default by a particular company (or country) known as the reference entity)

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13
Q

When did Credit Default Swaps emerge (CDS)?

A
  • Although it is said the business risk is the only risk that cant be insured against, CDS try to take on this role
  • emerged in the 1990s and the finance market grew steadily and then spectacularly until the financial crisis erupted in 2007 (their use increased almost tenfold in the three years prior to the financial crisis)
  • Before the financial crisis of 2007, there was more money invested in credit default swaps than in other pools. The value of credit default swaps stood at $4 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in US Treasury Bonds
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14
Q

What happened to CDS post-financial crisis?

A
  • CDS declines as spectacularly as they grew due to the size of the roll they played in the financial crisis, which made them a target for reforms since 2009
  • Post-crisis reforms have included standardisation of contracts, expanded reporting requirements, mandatory central clearing and margin requirements for a wide range of derivatives
  • All of these measures are designed to protect the integrity of the financial system and avoided CDS underpinning another financial crisis
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15
Q

What is the behaviour of hedging instruments?

A
  • Changes in the value of a hedging instrument are inversely correlated with changes in the price of the underlying, help limit loss when the underlying loses value
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16
Q

What is Credit Risk?

A
  • Credit risk is the probability that a borrower will default on a loan commitment to repay debt or bank loans.
  • Default occurs when the borrower cannot fulfil key financial obligations such as making interest payments to bondholders or repaying bank loans
  • In the event of default lenders, bondholders or banks suffer a loss because they will not receive all the payments promised to them
  • The probability of default isn’t constant during the upswing of the business cycle it declines and vice versa
  • Firm-specific risk is even less predictable since it is determined by events specific to that firm’s business activities or the industry in which it operates
17
Q

What are Credit Default Swaps?

A
  • Credit default swaps are privately negotiated bilateral contracts. They are sometimes referred to as synthetic securitisation.
    • They are synthetic because the originator retains ownership of the underlying asset whereas with the pure securitisation the originator pools the asset and sells the pool as the security
  • The buyer of protection makes periodic payments (premium) to the seller of protection. The premium is referred to as the credit default spread. The contract also specifies the maturity of the contract.
  • The seller of protection pays compensation to the buyer of protection in the event of a ‘credit event’- causes of financial distress. At this point, the payment is paid and the contract is terminated.
  • Generally, the provider of protection is much stronger than the buyer of protection (it would make no sense for the buyer to buy protection from weaker entity)
18
Q

What are the different types of Credit Events?

A

The contract that exists between the protection buyer and the protection seller stipulates the specific credit events that will lead to the settlement and termination of the contract.

The most common types of credit events are:

  • Bankruptcy –> reference entity becomes insolvent
  • Failure to pay –> cashflow problems, by divulging the details of the problem (temporary) will usually lead to the insurance provider to give a period of grace
  • Restructuring
19
Q

What is the process of providing a CDS?

A

e.g. is the Fee is 25bps per quarter

Payout is $100m minus value of the bond (debt ‘insured’) if a default occurs otherwise nothing is paid out.

In this example, the quarterly payment is $250,000. If a credit event occurs and the market value of the bonds ‘insured’ is $75m, Bank A receives 100m - $75m = $25m

outcome:

  1. If there is no default, the only cash flow is premium the ‘Protection provider’.
  2. If a credit event occurs, the transaction stops and claim is settled either physically or in cash.
    1. Physical settlement implies that the buyer of protection has the right to sell bonds with, our example, a face value of $100million issued by the protection provider (this is the normal settlement route)
20
Q

How is a credit event on a CDS settled in cash?

A

Cash settlement implies that a notional ‘final’ price is agreed and the seller of protection delivers notional of amount of the transaction (100) x (1- R) to buyer.

In our case, if agreement is reached that the bond is currently worth $75m, the amount paid out by the protection provider would be 100(1-0.75) = 25%($100,000,000m) = $25,000,000.

(practice questions on this)

21
Q

What is a Total Return Swap?

A
  • In a total return swap, Bank A (the protection seeker) agrees to pay Bank B (the protection provider) all contractual payments plus any appreciation in the market value of the subject (reference) bond, that is, the total return on the reference bond.
  • Bank B promises to pay Bank A Libor plus a spread specified basis points along with any depreciation in the value of the reference asset during the term of the swap
  • Protection given doesn’t
22
Q

Example of Total Return Swap?

A
23
Q

Why are Total Return Swap Attractive?

A
  • why would Bank A want to enter into a credit derivative arrangement such as a total return swap? Why would it not invest in a debt market instrument to obtain the same Libor + zbps?
  • If yield were the only consideration, this would e a perfectly appropriate strategy. But in reality, there are other considerations
    • the credit rating of the company is going to change in the future
    • might not get that yield
    • being doing business with company X for a number of years and want to preserve the relationship - it may go bust and become a higher credit risk, but if it doesn’t I want to stay its bank (don’t need to divulge this to company X)
      *
24
Q

Why do investors buy Credit Default swaps?

A

An investor can buy an entity’s credit default swap believing that it is too low or too high and attempt to make profits from it by entering into a trade - may be an arbitrage effect

Also, investors can buy credit default swap protection to speculate that the company is likely to default since an increase in CDS spread reflects a decline in creditworthiness and vice-versa - take a calculated risk

(CDS are used to also identify the creditworthiness of a borrower, although it may not accurately reflect the underlying nature of the risk) - but may reflect the best general information available

25
Q

What is Arbitrage?

A
  • Arbitrage is the practice of buying a security from one market and simultaneously selling it in another market at a higher price, therefore benefiting from a temporary difference in asset prices
  • Once an Arbitrage opportunity has been exploited the spread should be tightened. The act of taking the opportunity will mean it cannot be taken again as the market correct for this new information
  • However, if the company’s outlook fails to improve, the CDS spread should widen (arbitrage will still be happening if the market is slow to adjust to information) and the stock price would be expected to decline.
26
Q

How can CDS be used for Hedging?

A
  • Hedging is an investment aimed at reducing the risk of adverse price movements (stock movements, adverse movements in interest rates)
  • Banks may hedge against the risk that a borrower may default by entering into a CDS contract as the buyer of protection If the borrower defaults, the proceeds from the contract balance off with the defaulted debt
  • In the absence of a CDS, a bank may sell the loan to another bank or finance institution
  • The bank can manage risk by buying a CDS
    • Entering into a CDS contract allows the bank to achieve its diversity objective without damaging its relationship with the borrower since the latter is not a party to the CDS contract and would not even know anything about it
27
Q

What is concentration risk?

A
  • concentration risk occurs when a single borrower represents a sizeable percentage of a bank’s population borrowers
  • banks can manage this type of risk by buying CDS and taking advantage of hedging

This makes Credit derivatives advantages as they have the advantage of reducing credit concentration on certain counter parities

  • Bank A might want reduce its exposure to company X for certain loans or lines of credit which are already on Bank A’s books by entering into a derivative contract with a third party
28
Q

What are the three types of credit risk?

A

An investor who lends funds by purchasing a bond issue is exposed to three types of credit risk: default risk, credit spread risk, and downgrade risk.

  • Default risk is the credit risk in which the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed.
  • Credit spread risk is the risk in which an issuer’s debt obligation will perform poorly relative to other bonds due to an increase in its credit spread. If the credit spread increases, the market price of the bond issue will decline (assuming Treasury rates have not changed).
  • Downgrade risk refers to an unanticipated downgrading of an issue or issuer that will cause the credit spread to increase resulting in a decline in the price of the issue or the issuer’s bonds. Downgrade risk is closely related to credit spread risk.
29
Q

What is restructuring in terms of a credit event?

A
  • A restructuring occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms.
  • The terms that can be changed would typically include, but are not limited to, one or more of the following:
  • (i) a reduction in the interest rate,
  • (ii) a reduction in the principal,
  • (iii) a rescheduling of the principal repayment schedule (e.g., lengthening the maturity of the obligation) or postponement of interest payment,
  • or (iv) a change in the level of seniority of the obligation in the reference entity’s debt structure.