Credit Derivatives

 

Credit derivatives enable financial institutions to transfer credit risk to a third party There has been a huge increase in the trading of credit derivatives over the last 10-15 years Banks have been net buyers of credit protection, with insurance companies being net sellers
But what happens to the transfer of risk if the insurers themselves go bust? AIG had to be rescued by the US Government

Credit Default Swaps (CDS) are/were the most popular credit derivative with a circa 150% increase in trading during 2007
Significantly reduced trading volumes in 2008/2009
Financial Management of International Business Week 11

Credit Default Swaps (CDS)

 E.g.

the credit default buyer pays 70 basis points (bp) per year (annually) and the notional principal is $100m
Pays $700,000 annually as insurance If there is not a credit event, the buyer keeps the $700,000 per annum If there is a credit event, the seller of the protection buys $100m face value of bonds for $100m (physical settlement) or pays a cash equivalent derived from the difference between the par value and the current market price (cash settlement)

Financial Management of International Business Week 11

Credit Default Swaps (CDS)

 Periodic protection premium

payments by the buyer in return for a substantial payoff in the event of default by the reference entity  Can be used to eliminate the credit risk associated with a loan or bond position
Credit Event Payment A Sell Credit Protection to B Protection Premium B Lends to ABC

ABC (Reference Entity)

Financial Management of International Business Week 11

Collateralised Debt Obligations

 Same

principle as CMO, but relating to a more general portfolio of bonds, loans, etc  Split the portfolio into different tranches so that securities with different risk characteristics are created  Allows the most senior tranch to be rated AAA even though the portfolio is not of investment grade  Example taken from Hull
practically any type of risky debt can become collateral for a CDO Includes US sub-prime loans
Financial Management of International Business Week 11

Example Cash CDO

Tranch 1 1st 5% of loss Yield = 35% Debt 1 Debt 2 Debt 3 : : : : Debt n Average yield 8.50% Tranch 4 Residual loss Yield = 6% Trust SPV SIV Tranch 3 3rd 10% of loss Yield = 7.5% Tranch 2 2nd 10% of loss Yield = 15%

Example Cash CDO



The yield/principal payoffs add up to 8.5%

Tranch 1 Tranch 2 Tranch 3 Tranch 4 Principal 5.00% 10.00% 10.00% 75.00% Yield 35.00% 15.00% 7.50% 6.00% Total 1.75% 1.50% 0.75% 4.50% 8.50% Equity Tranch

AAA Rating

Tranch 1 has 5% of the bond principal and absorbs all credit losses up to the first 5%
Often referred to as the equity tranch Creator of the CDO often retains the equity tranch
Explains the write offs of some bank originators?

Default loss of 2.5% results in a 50% loss of principal Compensated by extremely high yield if no default

Financial Management of International Business Week 11