BITS Pilani presentation

BITS Pilani Shekhar Rajagopalan

Pilani Campus

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 BITS Pilani
Pilani Campus

FIN ZG514 Derivatives & Risk Management

Credit Derivatives
Chapter 25
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Types of Risks
• Market Risk: Risk of changes in prices of assets
• Equity prices, commodity prices, interest rates, bond prices, exchange rates,
index levels, derivative prices
• Credit Risk: The risk that the promised payment will not materialize
• Occurrence of default on the underlying obligation
• Risk of incomplete recovery in case of default

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Credit Default Swap

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Example
The bank holds a 5-year $10 million loan of a start-up X in its books. The bank
believes the company’s prospects are not bright for the next two years, but if it were to
survive the first two years, it will do well.
The hedge fund has another view of X. The start-up will do well sooner than later. It
offers protection to the bank over the two year period

The Bank pays a premium of 90 bps per year for two years on $10 million
• If X defaults in this period, the bank sells the loan to the hedge fund at par value
• If X does not default, the hedge fund earns 90 bps per year on $10 million for 2
years (That is, 0.90% of $10 million per year = $90,000 per year)

90 bps* per year

Bank Hedge Fund

Payoff if there is a default

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Terminology
• Credit Risk
• The bank sells the credit risk to the hedge fund
• The hedge fund buys the credit risk from the bank
• Protection
• The bank is the buyer of protection
• The hedge fund is a seller of protection

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Single-Name / Basket CDS
• CDS is the most common form of credit derivative and may involve municipal
bonds, emerging market bonds, mortgage-backed securities or corporate bonds.
Single-Name CDS
• Depends on the credit risk of a single entity
• There are trading platforms for single-name CDS
• Allows credit risks to be traded in the same way as market risks
• The higher the spread, the less faith the market has in the issuer
• The premium paid to buy a CDS
• Can be used to transfer credit risks to a third party
• Can be used to diversify credit risks

Basket CDS
• Depends on the credit risk of several entities
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Using a CDS to Hedge a Bond Position

Explain why the portfolio manager has constructed the following

portfolio: A 5-year par yield corporate bond that provides a yield of 6% &
a long position in a 5-year CDS on the face value of the bond with a
spread of 100 basis points pa

The 5-year bond yield is 6% pa

The 5-year CDS costs 1% pa.
The portfolio is equivalent to:
• A long position in a riskless instrument paying 5% per year

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Total Return Swap

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Total Return Swap (TRS)
A swap agreement
• A notional principal NP
• The Receiver makes payments based on a set rate, either fixed or variable on NP
• The Payer makes payments based on the return of an underlying asset, which
includes both the income it generates and the capital gains.
• The Referenced Asset
• The underlying asset
• Usually an equity index, loans, or bonds.
• The referenced asset may be owned by the Payer

https://www.investopedia.com/terms/t/totalreturnswap.asp

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TRS - Example
Total Return on Asset

Total Return Total Return

Payer Receiver
LIBOR plus 25bps

Swapping Total Return on a portfolio of assets for LIBOR plus 25 bps

• Total Return: Cash flows from the underlying assets as well any change in the
capital value of the underlying assets
• The Total Return Receiver transfers both the credit risk and market risk of the
underlying assets

• A synthetic long position in the asset for the receiver

• A synthetic short position in the asset for the payer
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TRS: Example
At Origination:
• One-year TRS
• NP of $1 million
• P receives the LIBOR plus a fixed spread of 1%.
• R receives the total return on the S&P 500 Index on the NP.

One year later: LIBOR = 3%

• If the S&P 500 appreciates by 15%
• P pays B 15%
• R pays A 4%
• The payment is netted with B R receiving $1 million * (15% - 4%)
• If S&P 500 falls by 15%
• P receives 15% + 4% on the NP
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Collateralized Debt Obligation

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Collateralized Debt Obligation (CDO)
• A structured financial product that pools together cash flow-generating assets and
repackages this asset pool into discrete tranches that can be sold to investors.
• The pooled assets – such as mortgages, bonds and loans – are essentially debt
obligations that serve as collateral for the CDO
• The tranches in a CDO vary substantially in their risk profile.
• The senior tranches are relatively safer because they have first priority on the
collateral in the event of default.
• As a result, the senior tranches of a CDO generally have a higher credit rating
and offer lower coupon rates than the junior tranches, which offer higher coupon
rates to compensate for their higher default risk.

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