Credit derivative

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In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk " [1] or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender [2] or debtholder.

Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

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An unfunded credit derivative is one where credit protection is bought and sold between bilateral counterparties without the protection seller having to put up money upfront or at any given time during the life of the deal unless an event of default occurs. Usually these contracts are traded pursuant to an International Swaps and Derivatives Association (ISDA) master agreement. Most credit derivatives of this sort are credit default swaps. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives. It is headquartered in New York City, and has created a standardized contract to enter into derivatives transactions. In addition to legal and policy activities, ISDA manages FpML, an XML message standard for the OTC Derivatives industry. ISDA has more than 820 members in 57 countries; its membership consists of derivatives dealers, service providers and end users.

Credit default swap financial swap agreement in case of default

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic collateralized debt obligations (CDOs), credit-linked notes or single-tranche CDOs. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite. [3]

Collateralized debt obligation financial product

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider.

Single-tranche CDO or bespoke CDO is an extension of full capital structure synthetic CDO deals, which are a form of collateralized debt obligation. These are bespoke transactions where the bank and the investor work closely to achieve a specific target.

History and participants

The market in credit derivatives started from nothing in 1993 after having been pioneered by J.P. Morgan's Peter Hancock. [4] By 1996 there was around $40 billion of outstanding transactions, half of which involved the debt of developing countries. [1]

The debt of developing countries refers to the external debt incurred by governments of developing countries, generally in quantities beyond the governments' ability to repay. "Unpayable debt" is external debt with interest that exceeds what the country's politicians think they can collect from taxpayers, based on the nation's gross domestic product, thus preventing it from ever being repaid. The debt can result from many causes.

Credit default products are the most commonly traded credit derivative product [5] and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations (see further discussion below).

On May 15, 2007, in a speech concerning credit derivatives and liquidity risk, Geithner stated: “Financial innovation has improved the capacity to measure and manage risk.” [6] Credit market participants, regulators, and courts are increasingly using credit derivative pricing to help inform decisions about loan pricing, risk management, capital requirements, and legal liability. The ISDA [7] reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). As reported in The Times on September 15, 2008, the "Worldwide credit derivatives market is valued at $62 trillion". [8]

Market value or OMV is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may or may not differ in some circumstances.

<i>The Times</i> British daily compact newspaper owned by News UK

The Times is a British daily national newspaper based in London. It began in 1785 under the title The Daily Universal Register, adopting its current name on 1 January 1788. The Times and its sister paper The Sunday Times are published by Times Newspapers, since 1981 a subsidiary of News UK, itself wholly owned by News Corp. The Times and The Sunday Times do not share editorial staff, were founded independently, and have only had common ownership since 1967.

Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%. [5]

The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. [5]

Types

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.

An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e., payments of premiums and any cash or physical settlement amount) itself without recourse to other assets.

A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. (The protection buyer, however, still may be exposed to the credit risk of the protection seller itself. This is known as counterparty risk.)

Unfunded credit derivative products include the following products:

Funded credit derivative products include the following products:

Key unfunded credit derivative products

Credit default swap

The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market. [5]

The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities. [9]

Total return swap

Key funded credit derivative products

Credit linked notes

In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes. Securitization-en.PNG
In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes.

A credit linked note is a note whose cash flow depends upon an event, which may be a default, change in credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note.

A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its note-like features, a CLN is an on-balance-sheet asset, in contrast to a CDS.

Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults.

Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments.

The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.

For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well.

The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.

Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.

There are several different types of securitized product, which have a credit dimension.

  • Credit-linked notes (CLN): Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
  • Collateralized debt obligation (CDO): Generic term for a bond issued against a mixed pool of assets—there also exists CDO-Squared (CDO^2) where the underlying assets are CDO tranches.
  • Collateralized bond obligations (CBO): Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO
  • Collateralized loan obligations (CLO): Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO

CDO refers either to the pool of assets used to support the CLNs or the CLNs themselves.

Collateralized debt obligations

Not all collateralized debt obligations (CDOs) are credit derivatives. For example, a CDO made up of loans is merely a securitizing of loans that is then tranched based on its credit rating. This particular securitization is known as a collateralized loan obligation (CLO) and the investor receives the cash flow that accompanies the paying of the debtor to the creditor. Essentially, a CDO is held up by a pool of assets that generate cash. A CDO only becomes a derivative when it is used in conjunction with credit default swaps (CDS), in which case it becomes a Synthetic CDO. The main difference between CDOs and derivatives is that a derivative is essentially a bilateral agreement in which the payout occurs during a specific event which is tied to the underlying asset.

Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.

Pricing

Pricing of credit derivative is not an easy process. This is because:

Risks

Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.

See also

Notes and references

  1. 1 2 The Economist Passing on the risks 2 November 1996
  2. Das, Satyajit (2005). Credit Derivatives: CDOs and Structured Credit Products, 3rd Edition. Wiley. ISBN   978-0-470-82159-6.
  3. Bruyere, Richard; Cont, Rama (2006). Credit Derivatives and Structured Credit: A guide for investors. Wiley. ISBN   978-0470018798.
  4. "AIG: America's Improved Giant". The Economist. London. February 2, 2013. Retrieved March 30, 2015.
  5. 1 2 3 4 "British Banker Association Credit Derivatives Report" (PDF). 2006.
  6. Remarks at the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference—Credit Derivatives, Sea Island, Georgia
  7. "ISDA". April 2007.
  8. Hosking, Patrick; Costello, Miles; Leroux, Marcus (September 16, 2008). "Dow dives as Federal Reserve lines up 75bn emergency loan for AIG". The Times. London. Retrieved April 30, 2010.
  9. Parker, Edmund; Piracci, Jamila (April 19, 2007). "Documenting credit default swaps on asset backed securities". Mayer Brown. Archived from the original on May 21, 2011.

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A bespoke portfolio is a table of reference securities. A bespoke portfolio may serve as the reference portfolio for a synthetic CDO arranged by an investment bank and selected by a particular investor or for that investor by an investment manager.