Chap 24 - Credit Risk and Credit Derivatives Flashcards Preview

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In fact, the non–U.S. Treasury fixed-income market is often referred to as the spread product market. This is because all other U.S.-dollar-denominated fixed-income products (e.g., bank loans, high-yield bonds, investment-grade corporate bonds, and emerging markets debt) trade at a credit spread relative to U.S. Treasury securities. Similarly, risky debt denominated in other currencies trades at a credit spread over the bonds of the dominant sovereign issuer in that currency


What is a Structural model ?


Structural models directly relate the valuation of debt securities to the financial characteristics of the economic entity that has issued the credit security. These factors usually include firm-level variables, such as the debt-to-equity ratio and the volatility of asset values or cash flows. The key is that structural credit models describe credit risk in terms of the risks of the underlying assets and the financial structures that have claims to the underlying assets (i.e., degree of leverage).


What is a Reduced-form credit model ?


Reduced-form credit models, in contrast, do not attempt to look at the structural reasons for default risk. Therefore, reduced-form credit models do not rely extensively on asset volatility or underlying structural details, such as the degree of leverage, to analyze credit risk. Instead, reduced-form credit models focus on default
probabilities based on observations of market data of similar-risk securities. In other words, reduced-form approaches typically model the observed relationships among yield spreads, default rates, recovery rates, and frequencies of rating changes throughout the market. The key feature of reduced-form credit models is that credit risk is understood through analysis and observation of market data from similar credit risks rather than through the underlying structural details of the entities, such as the amount of leverage.


What are the 3 factors that can determine an expected credit loss of a credit exposure ?

  1. Probability of default (PD), which specifies the probability that the counterparty fails to meet its obligations.
  2. Exposure at default (EAD), which specifies the nominal value of the position that is exposed to default at the time of default.
  3. Loss given default (LGD), which specifies the economic loss in case of default. The converse of LGD is the economic proceeds given default—that is, the recovery rate (RR). The recovery rate is the percentage of the credit exposure that the lender ultimately receives through the bankruptcy process and all available remedies. Therefore, LGD =(1− RR), and RR =(1−LGD).

THEREFORE: Expected Credit Loss =
PD × EAD × (1 − RR)


A risk-neutral approach to pricing a bond with credit risk: A risk-neutral approach models financial characteristics, such as asset prices, within a framework that assumes that investors are risk neutral. A risk-neutral investor is an investor that requires the same rate of return on all investments, regardless of levels and types of risk because the investor is indifferent with regard to how much risk is borne. Economic theory associates investor risk neutrality with investors whose utility or happiness is a linear function of their wealth.


Although the assumption of risk neutrality by investors is unrealistic, the power of risk-neutral modeling emanates from two key characteristics: (1) the risk-neutral modeling approach provides highly simplified and easily tractable modeling.

(2) in some cases, it can be shown that the prices generated by risk-neutral modeling must be the same as the prices in an economy where investors are risk averse.


When applicable, risk-neutral pricing provides extremely simplified
frameworks to price assets in a risk-averse world.


A risk-neutral probability is a probability-like value that adjusts the statistical probability of default to account for risk premiums. A risk-neutral probability is equal to the statistical probability of default only when investors are risk neutral; it should not be interpreted as the probability of default that would occur if investors were risk averse. Of course, investors are not risk neutral, and they demand a premium for investing in risky investments. To account for the risk premium, risk-neutral probabilities can be used rather than statistical probabilities. Other approaches to risk adjustment include use of higher discount rates and reduction of expected cash flows (the certainty-equivalent approach).


The risk-neutral probability of default is equal to the credit spread divided by the expected loss given default, or (1− RR). In the simple case of a risk-neutral world and a bond with no recovery (RR =0), the credit spread of a bond will equal its annual probability of default!


λ ≈ s / (1 − RR) and s ≈ λ * (1 − RR)

Where λ is a probability of default. It should not be interpreted as predicting an actual probability of default. Rather, λ should be viewed as a modeling tool. The actual probability of default will be less than λ to the extent that investors
demand a risk premium.

How to find it:

Given the bond’s forecasted cash flows, the current value (time 0) of the one-period bond, B(0,1):

B(0, 1) = K / (1 + r) (RR ×λ+ [1 − λ])

We then can also find the same answer with a credit spread ; expresses the current price (time zero) of this debt due in one year, B(0,1), using a credit spread:

B(0, 1) = K / (1 + r + s)

–> The risk premium required to hold a risky bond is expressed through the use of a higher discount rate: the addition of the credit spread, s, to the
riskless rate, r.

Equalizing both formulas gives the first equation ( to find lambda with a credit spread)


Explain : s ≈ λ * (1 − RR)


It indicates that s, the credit spread (the excess of a risky bond’s yield above the riskless yield), is equal to the expected percentage loss of the one-year bond over the remaining year under the assumption of risk neutrality. The expected annual loss is the product of the risk-neutral probability of default (λ) and the proportion of loss given default (1− RR).


What does it mean “to calibrate a model “ ?


To calibrate a model means to establish values for the key parameters in a model, such as a default probability or an asset volatility, typically using an analysis of market prices of highly liquid assets. For example, the volatility of short-term interest rates might be calibrated in a model by using the implied volatility of highly liquid options on short-term bonds.


What are the 2 advantages from using Reduced-form models ?

  1. They can be calibrated using derivatives such as credit default swap spreads, which are highly liquid.
  2. They are extremely tractable and are well suited for pricing derivatives and portfolio products. The models can rapidly incorporate credit rating changes and can be used in the absence of balance sheet information (e.g., for sovereign issuers).

What are the 4 disadvantages from using Reduced-form models ?

  1. There may be limited reliable market data with which to calibrate a model.
  2. They can be sensitive to assumptions, particularly chose regarding the recovery rate.
  3. Information on actual historical default rates can be problematic. That is, few observations are available for defaults by major firms or sovereign states.
  4. Historical default rates on classes of borrowers (e.g., borrowers of a particular ratings class) may have limited value in the prediction of future default rates to the extent that economies undergo major fundamental changes.

What is hazard rate ?


Hazard rate is a term often used in the context of reduced-form models to denote the default rate. The number is usually annualized and may be based on historical analysis of similar bonds or on expectations. Thus, an asset with a hazard rate of 2% is believed to have a 2% actual (i.e., statistical rather than risk-neutral) probability of default on an annual basis.


The primary way that credit derivatives contribute to the economy and its participants is by facilitating risk management in general and diversification


Derivatives are cost-effective vehicles for the transfer of risk, with values driven by an underlying asset. Credit derivatives transfer credit risk from one party to another such that both parties view themselves as having an improved position as a result of
the derivative. Roughly, most credit derivative transactions transfer the risk of default from a buyer of credit protection to a seller of credit protection.


What is Price revelation (price discovery) ?


Price revelation, or price discovery, is the process of observing prices being used or offered by informed buyers and sellers. Prices are the mechanism through which values of resources are communicated in a large economy.


What are the 3 major methods for grouping credit derivatives ?


1- Single-name versus multi-name instruments:
Single-name credit derivatives transfer the credit risk associated with a single entity. Most single-name credit derivatives are credit default swaps (CDSs).

Multi-name instruments, in contrast to single-name instruments, make
payoffs that are contingent on one or more credit events (e.g., defaults)
affecting two or more reference entities. Credit indices are examples of multi-name credit instruments. CDSs on baskets of credit risk offer specified pay-outs based on specified numbers of defaults in the underlying credit risks. In the most common form of a basket CDS, a first-to-default CDS, the protection seller compensates the buyer for losses associated with the first entity in the basket to default, after which the swap terminates and provides no further protection.

2- Unfunded versus funded instruments:
Unfunded credit derivatives involve exchanges of payments that are tied to a notional amount, but the notional amount does not change hands until a default occurs. An unfunded credit derivative is similar to an interest rate swap in which there is no initial
cash purchase of a promise to receive principal but rather an agreement to exchange future cash flows. The most common unfunded credit derivative is the CDS.

Funded credit derivatives require cash outlays and create exposures similar to those gained from traditional investing in corporate bonds through the cash market. Credit-linked notes, are a common type of funded instrument. They can be thought of as a riskless debt instrument with an embedded credit derivative.

3- Sovereign versus nonsovereign entities: The reference entities of credit
derivatives can be sovereign nations or corporate entities. Credit derivatives
on sovereign nations tend to be more complex because their analysis has to
consider not only the possible inability of the entity to meet its obligations
but also the potential unwillingness of the nation to meet its obligations. The
modeling of the credit risk associated with sovereign risk involves political
and macroeconomic risks that are normally not present in modeling corporate credit risk. Finally, the market for credit derivatives on sovereign nations is smaller than the market for other credit derivatives.


Both Smithson and Mengle have observed four stages in the evolution of credit derivatives activity. The first, or defensive, stage, which started in the late 1980s and ended in the early 1990s, was characterized by ad hoc attempts by banks to lay off some of their credit exposures. The second stage, which began about 1991 and lasted through the mid- to late 1990s, was the emergence of an intermediated market in which dealers applied derivatives technology to the transfer of credit risk, and investors entered the market to seek exposure to credit risk. Further, in 1999, the International Swaps and Derivatives Association (ISDA) issued a set of standard definitions for credit derivatives to be used in connection with the ISDA master agreement, as discussed in more detail later in the chapter. Finally, dealers began
warehousing risks and running hedged and diversified portfolios of credit derivatives. During this stage, the market encountered a series of challenges, ranging from credit events associated with restructuring to renegotiation of emerging market debts. The fourth stage centered on the development of a liquid market. With new ISDA credit derivative definitions in place in 2003, dealers began to trade according to standardized practices (e.g., standard settlement dates) that went beyond those adopted for other over-the-counter (OTC) derivatives.


What is a plain vanilla interest rate swap ?


In a plain vanilla interest rate swap, party A agrees to pay party B cash flows based on a fixed interest rate in exchange for receiving from B cash flows in accordance with a specified floating interest rate. Both payments are based on a notional principal and
a specified number of years, which typically range from two to 15 years.


In a plain vanilla interest rate swap, who is the payer and the reciever ?


The payer in a vanilla swap is the party that agrees to pay a fixed rate in exchange for receiving a floating rate. The receiver (i.e., the buyer of the fixed rate) is the party that agrees to pay a floating rate in exchange for receiving a fixed rate.


Credit risk and interest rate risk interact in fine ways. These interactions can be
examined by estimating the MTM value of swaps for a range of term-structure scenarios and credit-risk assumptions. These estimations can be performed using Monte Carlo simulation or other techniques.


Ferrara and Ali (2013) simulate many forward yield curves (using an arbitrage-free interest rate model), and evaluate the potential exposure of vanilla interest rate swaps under the most familiar yield curve shapes and under different volatility assumptions. The authors highlight that unanticipated changing interest rates can, on one hand, create substantial mark-to-market (MTM) or counterparty exposure, which may cause significant MTM losses and require substantial collateral posting. On the other hand, they also find that unanticipated changing interest rates can generate considerable MTM gains, which can lead to counterparty exposure if the swap contract is not collateralized.


What are the two key assumptions under which the traditional approach to pricing and valuing standard interest rate swaps is based ?


LIBOR discount factors are :

(1) reasonable proxies for the credit quality of the counterparty when the contract is uncollateralized.

(2) suitable measures for the risk-free term structure when the contract is collateralized.


What is a credit default swap (CDS) ?


A credit default swap (CDS) is an insurance-like bilateral contract in which the buyer pays a periodic fee (analogous to an insurance premium) to the seller in exchange for a contingent payment from the seller if a credit event occurs with respect to an underlying credit-risky asset. A CDS may be negotiated on any of a variety of credit-risky investments, primarily corporate bonds.


In a CDS, the credit protection buyer pays a periodic premium on a predetermined amount (the notional amount) in exchange for a contingent payment from the credit protection seller if a specified credit event occurs. The credit protection seller receives a periodic premium in exchange for delivering a contingent payment to the credit protection buyer if a specified credit event occurs.


How does a Total return swap works ?


Total return swap, the credit protection buyer, typically the owner of the credit
risky asset, passes on the total return of the asset to the credit protection seller in return for a certain payment. Thus, the credit protection buyer gives up the uncertain returns of the credit-risky asset in return for a certain payment from the credit protection seller. The credit protection seller now receives both the upside and the downside of the return associated with the credit-risky asset. The credit protection seller takes on all of the economic risk of the underlying asset, just as if that asset were on the balance sheet or in the investment portfolio.


What is The standard ISDA agreement ?


The standard ISDA agreement serves as a template to negotiated credit agreements that contains provisions commonly used by market participants.


What are the 5 specifications relating to a deal following that the standard ISDA
agreement provides ?

  1. CDS spread: The CDS spread or CDS premium is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.
  2. Contract size: ISDA does not impose any limits on size or length of
    term of a CDS; this is up to the negotiation of the parties involved. The notional value of most CDSs falls in the range of $20 million to $200 million, with a tenor (term) of three to five years.
  3. Trigger events: This is the heart of every CDS transaction. Trigger events determine when the credit protection seller must make a payment to the credit protection buyer. Both sides to a CDS negotiate these terms intensely.
  4. Settlement: If a credit event occurs, settlement can be made either with a cash payment or with a physical settlement. In a cash settlement, the credit protection seller makes the credit protection buyer whole by transferring to the buyer an amount of cash based on the contract. Cash settlement does not occur as frequently as one might expect, because it is difficult to agree on a good marketbased measure of the loss. Therefore, most CDSs use physical settlement upon the occurrence of a credit event. Under physical settlement, the credit protection seller purchases the impaired loan or bond from the credit protection buyer at par value. The credit-risky asset is physically transferred to the credit protection seller’s balance sheet, and the face or par value of the bond is transferred to the protection buyer from the protection seller.
  5. Delivery: Within particular limits, the credit protection buyer has a choice of
    assets that can be delivered for physical settlement. This raises the issue of which of those assets is cheapest to deliver.

What are the 7 kinds of potential trigger events provided by ISDA agreement ?

  1. Bankruptcy. A filing for bankruptcy is typically associated with a company’s
    inability to pay its debt.
  2. Failure to pay. Although a company may not be in bankruptcy yet, it may not be able to meet its debt obligations as they come due.
  3. Restructuring. This is any form of debt restructuring that is disadvantageous to a holder of the referenced credit.
  4. Obligation acceleration. All bond and loan covenants contain provisions that
    accelerate the repayment of the loan or bond if the credit quality of the borrower begins to deteriorate due to a number of events, such as a failure to pay, a bankruptcy (which ISDA covers independently), or a ratings downgrade.
  5. Obligation default. This is any failure to meet a condition in the bond or loan
    covenant that would put the borrower in breach of the covenant. It could be
    something like the failure to maintain a sufficient current ratio or a minimum
    interest earnings coverage ratio.
  6. Repudiation/moratorium. This is most frequently associated with sovereign or emerging markets debt. It is simply a refusal by the sovereign government to repay its debt as it comes due or even an outright rejection of its debt obligations.
  7. Government intervention. A government’s action or announcement reduces required payments or reduces the priority of making payments.

Keep in mind that although ISDA provides standard terms, the parties to a CDS can negotiate any and all terms, plus add their own if they both wish. The main point is that the standardization of CDS terms has provided the infrastructure for the huge growth of the credit derivatives market.


What are the 4 majors terms that defines a CDS ?

  1. Credit reference: CDS contracts specify a referenced asset. The referenced asset (referenced bond,referenced obligation, or referenced credit) is the underlying security on which the credit protection is provided. Following
    a credit event, particular qualifying bonds are deliverable. Typically, a senior unsecured bond is the reference entity, but bonds at other levels of the capital structure may be referenced.
  2. Notional amount: CDS contracts specify the amount of credit risk being transferred. This amount, agreed on by both the protection buyer and the protection seller, is analogous to the principal value of a cash bond.
  3. CDS spread: This is the annual payment rate, quoted in basis points. Payments are paid quarterly and accrue on an actual/360-day basis. The spread is also called the fixed rate, coupon, premium, or price.
  4. CDS maturity: Typically, CDS contracts expire on the 20th of March, June, September, or December. The five-year contract is usually the most common and most liquid.

What is a novation (assignment) ?


A novation or an assignment is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.


What are the 3 alternatives if a party of an OTC derivative decides to unwind a position ?

  1. Entering an offsetting position: The CDS exposure can be offset with a
    position either in another CDS contract or in one of the underlying deliverable
  2. Assigning the contract: Investors may be able to locate a dealer or another entity that will take over the rights and obligations of the contract with or without a cash payment from one party to the other. If so, the investor can assign (i.e., novate) the contract. The original counterparty must give permission for assignment because of the counterparty risk present in any CDS contract. The ISDA master agreement requires a transferrer to obtain prior written consent from the remaining party before a novation takes place.
  3. Terminating the contract: The CDS contract can be terminated with mutual consent if necessary by having one of the counterparties pay the other counterparty any lost value from discontinuing the swap.

Who are the 6 main participants in the credit derivatives market ?


Bank trading activities: Major banks serve as market makers in credit derivatives markets and were historically constrained in their ability to provide liquidity because of limits on the amount of credit exposure they could have in one
company or sector.

Bank loan portfolios: Banks were once the primary participants in credit derivatives markets. They developed the CDS market to reduce their risk exposure to companies to which they lent money or became exposed through other transactions, thus reducing the amount of capital needed to satisfy regulatory requirements.

Hedge funds: Since their early participation in credit derivatives markets, hedge funds have continued to increase their presence and the variety of trading strategies in the markets. Whereas the activity of hedge funds was once primarily driven by convertible bond arbitrage, many funds now use CDSs as the most efficient method to buy and sell credit risk.

Other asset managers: Asset managers use credit derivatives markets because they provide opportunities that the managers cannot find in the bond market,
such as a particular credit risk with a particular maturity. In addition, credit
derivatives markets provide a relatively easy method for avoiding cash sales or
overcoming difficulties of short selling.

Insurance companies: The participation of insurance companies in credit derivatives markets can be separated into two distinct groups: (1) life insurers and property-casualty companies, and (2) monolines and reinsurers. Life insurers and property-casualty companies typically use CDSs to sell credit protection to enhance the return on their asset portfolios. Monolines (providers of bond guarantees) and reinsurers often sell credit protection as a source of additional premiums and to diversify their portfolios to include credit risk.

Corporations: Operating firms use credit derivatives markets to manage credit exposure to third parties (e.g., accounts receivable). In some cases, the greater liquidity, transparency of pricing, and structural flexibility of the CDS market make it an appealing alternative to credit insurance or factoring arrangements.


What are the 5 main motivations for entering into CDSs ?

  1. Risk decomposition: Credit derivatives provide an efficient way to decompose and separate risks embedded in complex securities. CDS spreads reflect the price to bear pure credit risk.
  2. Synthetic shorts: Credit derivatives provide an efficient way to hedge credit risk through shorting credit (i.e., taking a position with a value that varies inversely with default).
  3. Synthetic cash positions: Credit derivatives offer ways to synthetically create loan or bond substitutes through tailor-made credit products. Credit derivatives are OTC instruments that can be tailored to provide investors with various choices for customizing their risk exposures. For example, investors can select maturities to express views about the timing of future credit events.
  4. Market linking: The high liquidity of credit derivatives can serve as a source
    of information that links structurally separate markets. The CDS market often reacts first and facilitates a reflection of revised prices in less liquid markets, such as bond or loan markets. For example, investors buying newly issued convertible debt are exposed to the credit risk in the bond component of the convertible instrument and may seek to hedge this risk using CDSs.
  5. Liquidity during stress: Credit derivatives provide liquidity in times of turbulence in the credit markets. Before the CDS market, a holder of a distressed or defaulted bond often had difficulty selling the bond, even at reduced prices, because cash bond desks are typically long credit risk due to owning an inventory of bonds.

What are Credit-linked notes (CLNs) ?


Credit-linked notes (CLNs) are bonds issued by one entity with an embedded credit option on one or more other entities. Typically, these notes can be issued with reference to the credit risk of a single corporation or to a basket of credit risks. A CLN with an embedded credit option on Firm XYZ is not issued by Firm XYZ. The CLN is like a CDS in that it is engineered to have payoffs related to the credit risk of Firm
XYZ while being legally distinct from Firm XYZ.


24.6.1 Term of Credit Options


Credit call options and credit put options provide individuals with a way to manage their exposure to credit risk, particularly in the context of credit-risky bonds or credit spreads. In simple terms, a credit call option allows the holder to potentially profit from an increase in the credit risk, while a credit put option allows the holder to potentially profit from a decrease in credit risk.

A credit call option: This option gives the holder the right to “buy” a credit-risky asset (typically a bond or a credit spread) at a predetermined price or rate. It is important to note that “buy” is in quotation marks because the option can apply to either a rate or a price, and rates are not usually bought or sold directly.

A credit put option: This option gives the holder the right to “sell” a credit-risky asset (usually a bond or a credit spread) at a specified price. Again, “sell” is in quotes because it can apply to either a rate or a price.

So, if you want to protect yourself from credit risk increasing (e.g., a bond’s price falling), you can establish a long position in a put option on a bond price or a call option on a credit spread. This will allow you to profit if credit risk rises and the underlying asset’s value declines.

Credit options can be traded on their own or be part of a more complex security or contract. They offer flexibility for investors and financial institutions to hedge or speculate on credit risk movements in the market.


How does a Credit-linked Notes (CLN) payout work ?


The holder of the CLN is paid a periodic coupon and then the par value of the note at maturity if there is no default on the underlying referenced corporation or basket of credits. However, if there is some default, downgrade, or other adverse credit event, the holder of the CLN receives a lower coupon payment or only a partial redemption of the CLN principal value.


What are CDS indices?


CDS indices are indices or portfolios of single-name CDSs. They are tradable products that allow investors to create long or short positions in baskets of credits and have now been developed globally under the CDX (North America and emerging markets) and iTraxx (Europe and Asia) banners. The CDX and iTraxx indices now encompass all the major corporate bond markets in the world.


What are the 5 key risks of credit derivatives ?

  1. Excessive Risk Taking: First, there is the risk that traders or portfolio managers may use CDSs to obtain excessive and imprudent leverage, either by design or by chance. Since these are off-balance-sheet contractual agreements, excessive credit exposures can be achieved without appearing on an investor’s balance
    sheet (although it should be discernible elsewhere in the accounts, such as in footnotes).
  2. Pricing Risk: OTC credit derivatives can involve pricing risk, including risk from valuation subjectivity. As the derivative markets have matured, the mathematical models used to price derivative contracts have become increasingly complex.
  3. Liquidity Risk: Credit derivatives that are OTC contractual agreements between two parties can be illiquid. A party to a custom-tailored credit derivative contract may not be able to obtain the fair value of the contract in exiting the position. Further, the legal documentation associated with a CDS usually prevents one party from selling its share of the CDS without the other party’s consent. CDS are likely to be market makers providing liquidity.
  4. Counterparty Risk: (OTC = counterparty risk). Exchange-traded derivatives are backed not only by the parties on the other side of the contracts but also by institutions, such as brokerage firms and clearinghouses.In the case of OTC options, there is only one side of a transaction that can be at counterparty risk: the long position. The reason that the long side faces counterparty risk is that if the option writer defaults, the option becomes worthless. Note that the credit protection buyer only suffers a counterparty loss when all three of the following conditions occur: the referenced entity experiences a credit event, the counterparty to the derivative defaults, and there is insufficient collateral posted to cover the loss. Note that the probability that the credit protection seller will default at the same time that the referenced asset of the CDS experiences a trigger event can be relatively high if both events are driven by the same macroeconomic factors.
  5. Basis Risk: In this context, basis risk is risk due to imperfect correlation between the values of the CDS and the asset being hedged by the protection buyer. The protection buyer takes on basis risk to the extent that the reference entity specified in the CDS does not precisely match the asset being hedged. (less customized, and less liquid, CDS) Ex: Bank using a CDS with a five-year maturity to hedge a loan with four years to maturity. Potentially higher liquidity in CDSs with five years to maturity. However, the protection buyer takes on basis risk because the four- and five-year loan values could potentially experience different price movements.

After a swap is initiated, it is possible for market prices to move such that one side of the contract has a positive market value and the other side has a negative market value. The side with the positive market value clearly
has counterparty risk. The side with the negative market value has counterparty risk to the extent that it is possible that the market value may become positive.