drake drake university fin 288 credit derivatives finance 288 futures options and swaps
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DrakeDRAKE UNIVERSITY
Fin 288
Credit Derivatives
Finance 288Futures Options and Swaps
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Fin 288Credit Risk
Default RiskThe risk that the debtor or counterparty will default on its obligation.
Migration / Deterioration RiskThe risk that there will be decline in the credit quality of the of the debtor or counter party.
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Fin 288Credit Default Swap
The buyer makes an upfront payment or a stream of payments to the seller of the swap.The seller agrees to make a stream of payments in the event of default by a third party on a reference obligation.
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Fin 288Basic Credit Default Swap
Default Swap Buyer
DefaultSwapSeller
Reference
Obligation Issuer
Upfront Payment orStream of payments
Payment in the Event of Default
Return on
Reference
Obligation
OriginalPayment
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Fin 288
Credit Default Swap as an Option
The Credit Default Swap is basically a put option on the reference obligation.The default buyer owns the put option which effectively allows the reference obligation to be sold to the CDS seller in event of default.
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Fin 288Intuition
Assume that the reference obligation is a bondIf the price of a bond decreases due to a change in credit quality, the value of the put option increases. This implies that the value of the CDS increases.The CDS buyer could sell the obligation at a premium compared to what was paid originally.
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Fin 288What Constitutes Default
The CDS parties can agree to any or all of the events below
BankruptcyFailure to PayObligation AccelerationObligation DefaultRepudiation or deferralRestructuring
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Fin 288
What Does not Constitute Default
Downgrade by rating agencyNon Material events (error by employee causing a missed payment etc.)
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Fin 288Hedge against Default
In the event of a default the swap buyer is hedged against the risk of default.The CDS is effectively an insurance policy against default.The risk of default is transferred to the seller of the CDS.
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Fin 288
Hedge against credit deterioration?
Since rating agency changes do not constitute default how are credit changes hedgedIf the CDS is marketed to market then the change in value serves as a hedge against changes in credit quality
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Fin 288An Example
Assume that the CDS buyer owns an 7% coupon bond and the return on a similar maturity treasury is 5%.Assume that both bonds have a current value of $1 Million (equal to their par value)Assume the buyer pays 2% per year for the duration of the swap and receives $1 Million in the even of default.The combination of the CDS and 8% bond have effectively the same payoff as the treasury
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Fin 288Credit Default Swap
Default Swap Buyer
DefaultSwapSeller
Reference
Obligation Issuer
2% per year
$1 Million in the Event of Default
7% per year
$1 Million
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Fin 288Risks in the CDS
The CDS seller may defaultWe assumed that the spread between the two bonds stays constant over time and that the duration and convexity of the bonds stays the same. (unlikely especially for a bond closeto default)We have ignored accrued interest There could be a liquidity premium for the risky bond causing it to sell for less than its true value.
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Fin 288Other CDS variations
Binary or Digital Default Swap – Payoff is a single lump sum often based upon recovery rates.Basket CDS - the reference obligation is a basket of obligations
N to default – default exists when the Nth obligatin defaults First to default
Cancelable DS –either the buyer (call) or seller (put) has the right to cancel the default swap
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Fin 288CDS Variations continued
Contingent CDS – triggered if both the default and a second event occurLeveraged CDS – Payoff is a multiple of the loss amount often the standard CDS amount plus a % of the notional valueTranched Portfolio Swaps – A variation of CDOs
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Fin 288Benefits of CDS
The risk is transferred to a financial institution that often has better ability to hedge the risk than the swap buyer.Allows lenders to hedge the risk of high risk loans without jeopardizing the lender – client relationshipReduction of regulatory capital.
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Fin 288A costless reduction in risk
Assume that Bank A has sold a CDS to Co X on a 100,000,000 notional amount and is receiving a 3% semi annual interest rateSimilarly Bank B has the same agreement with Co Y.Assuming both company’s have the same credit qualityBy exchanging a portion of the notional value of the swap the banks can diversify the credit risk without any costs.
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Fin 288
Credit Default SwapRisk Sharing
Bank
A
Company
X
$50 M of CDSWith Co X
$50 M of CDSWith Co Y
Company
Y
3% on $100M
Bank
B
Payment If Default
Payment If Default
3% on $100M
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Fin 288An arbitrage example
Assume that a foreign country is undergoing a financial crisis and bonds based in the country are trading at a high yield of 18%However the CDS premium on the foreign bond is 11%Currently the treasury yield is 5%By shorting the treasury and using the proceeds to buy the foreign bond, the firm can lock in a profit.
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Fin 288
Credit Default SwapArbitrage
Arbitrageur
Treas Bond
Buyer
Cash
18% Yield
Company
Y
11% Premium
Foreign bond Seller
Payment If Default
Treas Yield 5%
Cash
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Fin 288
Adjusting Regulatory CapitalA Banking Example
Basel II Accords have specified how risk based capital should be calculated based upon a weighted riskiness of an asset.
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Fin 288New Basel Accord (Basel II)
Basel Agreement – imposes risk based capital requirements on banks in major industrialized countriesPillar 1: Credit, market, and operational risksCredit risk:
Standardized approachInternal Rating Based (IRB)
Market Risk --Unchanged
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Fin 288Basel II continued
Operational:Basic IndicatorStandardizedAdvanced Measurement Approaches
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Fin 288Basel II continued
Pillar 2Specifies importance of regulatory review
Pillar 3Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks
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Fin 288Capital
Divided into Tier I and Tier IITier I – closely linked to book value, represents the core contributions to banks owners. Includes common stockholders equity, some preferred stock, equity interests of subsidiaries Tier II – secondary capital. Includes loan and lease losses, hybrid capital (perpetual debt), subordinated debt, revaluation reserves
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Fin 288Risk-based Capital Ratios
Basle I AgreementEnforced alongside traditional leverage ratioMinimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio.Also requires, Tier I (core) capital ratio
= Core capital (Tier I) / Risk-adjusted 4%.Crudely mark to market on- and off-balance sheet positions.
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Fin 288Calculating Risk-based
Capital Ratios
Tier I includes:book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill.
Tier II includes:loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps
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Fin 288Calculating Risk-based
Capital Ratios
The risk based capital ratio is based upon the risk weight. The minimum amount to be in capital is 8% multiplied by the risk weight and the notional value of the loan.For example if you made a loan to an A rated corporation it would have a risk weight of 50%.On a $100M loan the required capital would be$100M(.5)(.08) = $4 Million
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Fin 288CDS and risk based capital
The original risk weight for the buyer of the credit derivative was defined asr*=wr+(1-w)g
where w = .15 for all credit derivatives giving protection
r = risk weight of the obligor g = risk weight of the protection
seller
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Fin 288An example
Assume that you have made a $1,000,000 loan to a corporation with an A rated corporation as before. However now you offset it with a CDS sold by a AAA rated bank with a risk weight of 20%.r* = .15(.50)+(1-.15).20 = .245This implies a capital requirement of.245(1,000,000)(.08) = $19,600 as opposed to.50(1,000,000)(.08) = $40,000
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Fin 288Weights
The 15% weight for the CDS is designed to cover operational risks that might make enforcement of the CDS difficult.The 15% has received much critisisim and a counter proposal would allow the risk weight to be set equal to the credit quality of the seller of the CDS. This could increase, or decrease the new risk weight depending upon the ratings of the original borrower and the CDS seller
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Fin 288CDOs