week 11 Flashcards
what are credit derivatives
•A credit derivative is a contract where the payoff depends on the credit worthiness of one or more commercial or sovereign entities.
Their purpose is to allow credit risks to be traded and managed in much the same way as market risks
•Credit Default Swaps (CDS)
–A contract that provides insurance against the risk of default by a particular company.
–Reference company
•The company which may be at risk of default.
–Credit event
•When default occurs.
•Credit Default Swaps (CDS)
what does the buyer obtain?
- The buyer of this type of insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event (default) occurs.
- Reference obligation
–The bond that is issued.
•Notional principal
–The total par value of the bond that can be sold.
•Credit Default Swaps (CDS)
what does the buyer obtain?
- The buyer of this type of insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event (default) occurs.
- Reference obligation
–The bond that is issued.
•Notional principal
–The total par value of the bond that can be sold.
when may you use a CDS
–You buy a bond off a particular company.
–In return for buying that bond, you expect to be paid coupons on the bond, and the face value of the bond at maturity.
–You fear that the company may default on the payment of those coupons, or the payment of the face value of the bond.
–Hence, you take out a CDS.
Mechanics of CDS
What do you get in return?
–In return for buying this CDS, you must make periodic payments to the seller of the CDS until the end of the life of the CDS, or until a credit event occurs (default by the company that issued you the bond).
Mechanics of CDS
what happens when the credit event occurs?
–If a credit event occurs, the party that sold you the CDS, must settle the swap either by physical delivery or in cash.
–You must pay any interest that has accrued up to the date of the credit even.
Mechanics of CDS
what happens when the credit event occurs and the terms require physical delivery?
–If the terms of the swap require physical delivery, then you (the swap buyer) deliver the bond (originally issued by the company which has defaulted) to the seller of the swap in exchange for the par value of the swap.
Mechanics of CDS
what happens when the credit event occurs and there is a cash settlement
–When there is cash settlement, a calculation agent polls various dealers to determine the mid-market price (Q), of the reference obligation within a specified number of days after the credit event.
Cash settlement is then (100 – Q)% of the notional principal
total return swap
–Involves the return on one asset or group of assets being swapped for the return on another.
–can be useful to diversify credit risk by swapping one type of exposure for another.
•Credit Spread Options
provides a payoff when the spread between the yields on two assets exceeds some pre-specified level
example of credit spread option
–Consider an investor with an investment in YEN denominated bonds issued by Australia.
–The investor could purchase an option that pays off whenever the yield on the YEN bonds exceeds the yield on Australian Treasury Bills by 600 basis points.
–The payoff could be calculated as the difference between the value of the bond with a 600 basis point spread and the market value of the bond.
–The option limits the investor’s exposure to the underlying sovereign credit.
•
example of total return swap
–Plane Bank is primarily concerned with lending to the airline industry.
–Oil Bank is primarily concerned with lending to the oil industry.
–To reduce its credit risk, Plane Bank could enter into a total return swap, where the return on one of its loans is exchanged for the return on an Oil Bank loan. This would achieve credit risk diversification for both sides (assume both loans are for the same notional principal).
–Alternatively, each bank could separately exchange the return on one of their loans for a LIBOR based return. This would have the effect of passing the credit risk on to someone else.
•Example of a CDS:
–Two parties enter into a five year CDS on March 1, 2000.
–The notional principal is $100 million.
–The buyer of the CDS agrees to pay 90 basis points annually for protection against default by the reference entity.
what happens if the reference entity does not default
–If the reference entity does not default, then the buyer of the CDS receives no payoff, and pays $900,000 on March 1 each of the years 2001, 2002, 2003, 2004 and 2005.
•Example of a CDS:
–Two parties enter into a five year CDS on March 1, 2000.
–The notional principal is $100 million.
–The buyer of the CDS agrees to pay 90 basis points annually for protection against default by the reference entity.
what happens if the reference entity defaults in September 2003 (halfway through 4th yr)
- If the contract specifies physical settlement, the buyer of the CDS has the right to sell $100 million par value of the reference obligation for $100 million.
- If the contract requires cash settlement, and a poll of dealers value the reference obligation to be $35 per $100 of par value, the cash payoff would be (100-35)x100 million = $65 million.
- In either case, the buyer of the swap would be required to pay accrued interest of $450,000 from March 1 2003 to September 1 2003.
. Weather Derivatives
hedging against adverse weather conditions
