L16 - Credit Derivatives Flashcards
What are Credit Default Swaps?
- 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.
Why were credit derivatives developed?
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.
what is credit risk?
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
How is a firm’s credit risk measured?
- 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.
How are bond issuers and investors affected by credit risk?
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.
Why is the credit risk faced by banks high?
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
- The concentration of loans geographically.
- Tend to focus on specific industries, means they can be affected by industry-specific changes
- Credit risk is the predominant risk in loans made to businesses
- Because they make big loans there is a limit to how much they can diversify their portfolio
- interest rates adjust on a loan based on the state of the economy or the assessment of a companies
How can securitisation be used to manage credit risk?
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
Before the implementation of credit derivatives, what were securitisation only loans like?
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
What was the primary reason for the creation of credit derivatives?
- 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.
How are credit derivatives different from actual insurance policies?
- 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
How do insurers manage risks?
- 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
How big is the Credit Derivative market?
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)
When did Credit Default Swaps emerge (CDS)?
- 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
What happened to CDS post-financial crisis?
- 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
What is the behaviour of hedging instruments?
- 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
What is the process of providing a CDS?
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:
- If there is no default, the only cash flow is premium the ‘Protection provider’.
- If a credit event occurs, the transaction stops and claim is settled either physically or in cash.
- 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)
What is a Total Return Swap?
- 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
Example of Total Return Swap?
