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Credit Derivatives Basics: An Overview

ASPAC Capital Markets RPC

Sydney RPC Level 14, 2 Park Street Sydney NSW 2000 Australia

Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

Credit Derivatives

Definition & Characteristics:

It is a financial contract used to mitigate or assume specific forms of


credit risks by hedgers or speculators

Ability to transfer risks relating to price of credit, without transfer of


underlying assets

Separation of credit risk from funding / liquidity risk Creation of array of unfunded credit products
Leading to

increased credit risk trading opportunities increased investor access to credit products

Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

Credit Default Swaps (CDS)

Definition:

CDS are credit derivatives in which Protection buyer pays periodic fee
to Protection seller and Seller covers Buyer against default

On occurrence of predefined credit event in relation to reference entity,


seller pays a contingent amount to buyer

CDS transfers the potential loss on an reference asset that can result
from specified credit events such as bankruptcy, default etc

Factors affecting the Fees (Pricing):

Asset swap price of reference asset


Repo cost of reference asset Counterparty risk

Correlation
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CDS Payoffs

No credit event before maturity:


X bps p.a. on Notional Amount

Protection Buyer

Protection Seller

CDS Payoffs (Contd.)

Credit event before maturity (contd.):

Option 1 Physical Delivery:


Notional Amount

Protection Buyer
Deliverable Obligations of the Reference Entity

Protection Seller

Option 2 Cash Settlement:


Settlement Amount

Protection Buyer

Protection Seller

Settlement Amount = Notional Principal x (Par - Recovery Value)%

CDS Payoffs (Contd.)

Physical Delivery Vs Cash Settlement:

Contingent Payments most often are computed in one of two ways

Net cash settlement (100% - Recovery Value of reference asset),


determined by dealer-poll of Reference Entity

Physical delivery of defaulted obligations of the reference entity


Choice of Cash or Physical settlement influenced by:

to Seller

Illegality and Impossibility of Physical Delivery View on the potential price of relevant assets of the defaulted entity after a
certain time period

Liquidity of the underlying security Protection buyer may have access to Cheapest-to-Deliver bond

CDS Key Features

Key Features:

Reference Entity can be a single credit (sovereign or corporate) or the


first-to-default in a basket of credits

Buyer either delivers defaulted obligations of the reference entity to


Seller or net cash settlement of the market value

Buyer decreases exposure to Reference Entity, but assumes contingent


exposure to Seller. Correlation between credit of Reference Entity and Seller will affect premium.

Provide a means to hedge illiquid credit exposures on an anonymous


basis and allow transfer of credit risk without transfer of ownership

May be more flexible and efficient than traditional credit risk


management tools collateral, shorting securities, reinsurance, guarantees

CDS Applications

Buyer Applications:

Synthetically short security Hedge credit on held asset Diversify concentrated portfolio

Seller Applications:

Unfunded position; create leverage Higher return than cash instruments

Generate income on unutilized credit lines


Off balance sheet credit exposure Diversify concentrated portfolio

Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Total Return Swaps (TRS)

Definition:

TRS transfer the returns and risks on an underlying reference asset


from one party to another

The buyer pays a periodic fee to seller and receives total economic
performance of underlying reference asset in return

Total Returns include interest payments + amount based on change in


assets market value

So if price goes up, buyer gets and amount = appreciation in value If price goes down, buyer pays an amount = decline in value

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TRS Payoffs

Payoff:

Receiver earns coupons + periodic positive MTMs on reference asset Receiver pays Libor + Margin + periodic negative MTMs on reference
asset

Transfers total performance without transfer of asset Captures spread movement and default Unfunded equivalent of funded asset purchase
Total positive returns on Ford Bond Receiver LIBOR + Margin + Losses on Reference Bond Payer

Synthetic long bond position

Synthetic short bond position

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TRS Features

Applications:

Self-financing; create leverage Lock in funding rate Access to new markets/securities with no repo market

Pricing:

Margin depends upon:

Cost of funds and capital Repo cost of reference asset Counterparty risk Correlation

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Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Credit Linked Note/Deposits (CLN/ CLD)

Definition & Key Features:

These are securities that effectively embed default swaps within a


traditional fixed income structure. They typically pay periodic interest plus, at maturity, the principal minus a contingent payment on the embedded default swap

CLN/CLD are, unlike CDS, funded instruments which allows the credit
protection buyer to avoid the contingent credit exposure to the protection seller.

Designed to resemble a synthetic bond or loan and offers investors


tailored credit exposure.

The CLN/CLD is payable in full at maturity unless a Credit Event


affecting the Reference Entity occurs during the instruments life. The coupon of the CLN/interest on CLD reflects the issuers funding cost plus an amount to compensate for the credit risk of the Reference Entity
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CLN/ CLD (Contd.)

Definition & Key Features:

If the Reference Entity suffers a Credit Event, the investor receives


either physical bonds or a cash amount equivalent to the post-default market value of the physical bonds. The note/deposit is then terminated

The default contingency is very flexible and may be linked to various


underlying assets (loans, securities)

The amount of exposure/risk taken can also be structured so as to


provide full or partial protections of principal

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CLN/ CLD Payoff

On Trade date:

Assume Principal amount = $ 10 MM


USD 10 mio

Note Issuer

Investor

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CLN/ CLD Payoff (Contd.)

No Credit Event before Maturity:


USD 10 MM + Interest * USD 10 MM at Maturity Note Issuer Investor

Credit Event before Maturity:


USD 10 MM equivalent of Deliverable Obligations of the Reference Entity Note Issuer No payments after Credit Event Investor

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CLN/ CLD Applications

For Investors:

CLNs offer cash-based investors access to:

New credit risks Credit risk in new currencies Credit risk for unavailable maturities
CLNs provide yield leverage (more than one name exposure) CLNs provide the portfolio effects of diversification However, these are complex to execute and have less liquidity vs.
Eurobonds)

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CLN/ CLD Applications (Contd.)

For Issuers:

CLNs provide an effective mechanism to transfer credit risk

For hedging Shorting credit risk (spread)


Primary markets; credit arbitrage-driven financing Diversification of the investor base Alternative to ABS Simpler; no asset-holding issuer vehicle Assets not transferred; relationship impact

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Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Credit Spread Options

Definition & Key Features:

Option seller gives right to buyer to buy/sell asset at agreed spread over Libor E.g., A put option on credit spreads gives the buyer the right but not the
obligation to sell the underlying asset/purchase credit default protection at a certain pre-specified credit spread

This effectively gives the buyer of a credit spread put option protection against
credit spreads widening at a future date

Spread is usually calculated as yield differential between reference bond and


interest rate swap of same maturity

Unlike CDS or TRS, counterparties DO NOT have to define a specific credit


event payoff happens regardless of reasons for credit spread movement

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Credit Spread Options Payoff

E.g.:

Bank C owns asset XYZ at L+20 bp but needs credit line Bank D will buy asset at L+25 bp Bank C buys 1 year put struck at L+25 bp for 10 bps Bank C replaces XYZ risk with Bank D risk Bank D takes contingent credit risk on XYZ

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Credit Spread Options Payoff

E.g.:
premium 10 bp

Bank C

sells asset at L + 25 bp option lapses

Bank D

L + 20 bp if spread > 25 bp

XYZ bond

if spread < 25 bp

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Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Portfolio Products

FIRST-TO-DEFAULT BASKETS:

A credit default swap in which swap returns are linked to first default in a
basket of issuer.

The exposure to each name is for full notional of the protection and principal
and interest are at risk only to the Reference Entity being the first to default.

Namely, if one of the Reference Entity in the First-to-Default Basket suffers a


Credit Event, the protection seller receives either physical bond of the defaulted Reference Entity or a cash amount equivalent to their post-Default market value. The transaction is then cancelled.

Cheaper than buying single name default swaps for each name in the basket
Buying 2nd and 3rd etc. to default increases extent of credit protection Spread of worst credit < basket swap spread < Sum of spreads of individual
credits
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Portfolio Products (Contd.)

FIRST-TO-DEFAULT CLN EXAMPLE:

Principal Amount: USD 10 mio Maturity: 5 years Interest: Libor + 270 bps p.a. (semi-annually) Reference Basket:

Reference 1 Reference 2 Reference 3


At Trade date:
USD 10 mio

Note Issuer

Investor

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Portfolio Products (Contd.)

FIRST-TO-DEFAULT CLN EXAMPLE:

No Credit Event Before Maturity:


USD 10 mio + Interest * USD 10 mio at Maturity

Note Issuer

Investor

First Credit Event among Reference 1,2 and 3 Before Maturity:


USD 10 mio equivalent of Deliverable Obligations of the Defaulted Reference Entity

Note Issuer

Investor
No payments after Credit Event

Investor

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Hybrid Products

Quanto Credit Default Swaps:

A structured credit default swap where the notional is denominated in a nonstandard (non-G7) currency

This allows protection buyers to avoid currency mismatches between the


bought credit protection and their underlying exposures

Credit Contingent Swaps (Disappearing/Extinguishing Swaps):

A swap that will be terminated with zero termination value upon the occurrence
of a credit event on the swap counterparty and/or a third-party reference credit.

The risks will be dynamically managed using a combination of credit products


as well the various market-risk factors (that determines the mark-to-market value of the swap)

Key considerations:Right-way exposure and correlation

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Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Key Legal Aspects

Documentation:

ISDA Master Agreement Confirmation

Conditions of Payment:

Define Credit Event (Default)

Bankruptcy Cross Acceleration / Cross Default Failure to pay (on what / how much?) Restructuring Repudiation Credit Spreads widening etc
Publicly Available Information like Reuters / Telerate etc
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Table Of Contents

Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products

Key Legal Considerations


Appendix Key Abbreviations

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Appendix Abbreviations Used


MTM: Mark to Market CDS: Credit Default Swap BP: Basis Point TRS: Total Return Swap CLN: Credit Linked Note CLD: Credit Linked Deposit Mio: Million

MM: Million

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