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Select the China site in Chinese or English for best site performance. Other MathWorks country sites are not optimized for visits from your location. Toggle Main Navigation. Search MathWorks. Credit Derivatives. Trial software Contact sales. Investors can pick up additional yield without buying an asset, holding it on their balance sheet and funding it.

Building on the basic swap structure, investors can swap the default risk of one credit with that of another credit. This can help companies diversify their portfolios while avoiding the transaction costs associated with buying and selling many individual securities or loans. Credit events in such transactions are pre-defined in the agreement, which could include a payment default, bankruptcy or debt rescheduling.

The credit event must be material and objectively measurable, this has been one of the major issues addressed by the International Swaps and Derivatives Association discussed in Section 5. The reference credit can be almost any loan or security, a basket of loans or securities, regardless of the currency, and the tenure of the swap can match or be shorter than the tenure of the reference credit.

Buying or selling an option on a borrower's credit spread provides an opportunity to gain exposure on the borrower's future credit risk. One can lock in the current spread or earn premium for the risk of adverse movement of credit spreads.

Catalog Record: Credit derivatives : understanding the | HathiTrust Digital Library

It also presents a method of buying securities on a forward basis at favorable prices. Credit Spread Options are normally associated with bonds, which are priced and traded at a spread over a benchmark instrument of comparable maturity.

The yield spread represents the risk premium the market demands for holding the issuer's bonds relative to holding riskless assets like U. Options can refer to the borrower's spread over U.

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For example, an investor might sell an option on the credit spread of a BBB-rated corporate bond with 5-year maturity to a bank in exchange for a premium up front. The option gives the bank the right to sell the bond to the investor at a certain strike price assume basis points. The strike price here is expressed in terms of credit spread over the 5-year Treasury note. On the option's exercise date, if the actual spread of the corporate bond is less than basis points, the option expires worthless. If it is higher than basis points, then the investor delivers the underlying bond and the investor pays the price whose yield spread over the benchmark equals basis points.

This structure allows investors to buy the bonds at attractive terms. If the option expires worthless, the total cost of bond is reduced by the amount of the premium. Otherwise the investor pays for the bond at the chosen strike price. There could be different strategic variations of this, such as i using options on credit spreads to take position on the relative performance of two different bonds and ii locking in the current spread by buying calls and selling puts on the spread with the possibility of earning a premium in the transaction.

Again, this derivative structure allows investors to take a position in the underlying assets synthetically rather than buying assets in the cash market. Credit spread options also give end users protection in the event of a large, unfavorable credit shift, which falls short of default. Spreads should move to reflect any downgrading in the credit rating. End users who purchased spread options will be able to cash in even though the referenced credit has not defaulted. The Credit-Linked Note market is one of the fastest growing areas in the credit derivatives sector.

Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk and investors a higher yield for buying a credit exposure synthetically rather than buying it in the publicly traded debt. Investors buy the securities from the trust that pays a fixed or floating coupon during the life of the note.

At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. Here the investor is, in fact, selling the credit protection in exchange for higher yield on the note. The trust on the one hand enters into a default swap with a deal arranger. In the case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee.

This annual fee is passed on to the investors in the form of a higher yield on the notes. In this structure, the investors can obtain higher yield for taking the same risk as the holder of the underlying reference credit. The investor does, however, take the additional risk, albeit limited, of its exposure to the AAA-rated trust.

The Credit-Linked Note allows a bank to lay off its credit exposure to a range of credits to other parties. Morgan has completed one of the more noted CLN transactions, which was based on the credit of Wal-Mart. They transform one or more attributes of the underlying asset, or basket of assets, and enable investors to benefit from derivative technology without directly entering into a derivative transaction. In a typical transaction, each investor purchases an Asset Linked Trust Security ALTS certificate, which represents an interest in a separate and independent trust and entitles the investor to participate in the cash flows from the underlying instruments.

ALTS trusts can accommodate all kinds of financial assets and credit derivatives and provide the same benefits as the derivative instruments themselves. For example, they allow investors to access the bank loan market without the operational or administrative burdens of syndicated loan participation. They provide a cheaper, simpler and more efficient alternative for investors to diversify their credit exposure through the purchase of a basket of loans or securities and derivatives. Chase Secured Loan Trust notes offer investors access to the high-yield bank loan market.

Credit Derivatives: Instruments, Applications, and Pricing

One of the attractive aspects of this market to investors is that, while offering double-digit returns in many cases, the senior-secured status of bank loans has given them a very stable, and favorable, default percentage over the years. The Chase structure uses credit derivatives to offer these investors access to this asset class.

Take, for example, an investor who is prohibited from investing in anything lower than investment grade securities. In the Chase structure, the underlying credit derivative is a Total Return Swap between Chase and a trust. An investor who purchases a tranche of the CSLT in the form of a note receives the same return on the loan portfolio that is received by the trust from Chase on the TRS. Credit risks are one of the most significant risk classes for financial institutions. Until recently, there has not been a developed, liquid market for trading credit risk.

Financial institutions have concentrated on their net market exposure sometimes at the expense of increasing the credit risk to certain companies.

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Credit derivatives allow financial institutions to change their exposure to a range of credit-related risks. As outlined above, there are different structures which allow the transference of credit risk from one party to another. The choice of the product depends upon the goals a financial institution is looking to achieve. In some cases, the bank can buy protection in the form of default puts to transfer the credit risk to an insurance company or other institutional investors. Additionally, the bank may swap one credit for another credit of equal rating, just to reduce its exposure to one party.

The following example walks through a TRS transaction, starting with the situations of the parties involved, then proceeding to the credit derivative solution. Party A is a smaller Texas-based bank with a concentration of loans and revolving credit lines to a group of independent oil and gas producers, as well as energy service companies, whose interests are tied heavily to the development of new offshore natural gas field in the Gulf of Mexico.

All companies are privately held with their rights to various parcels of the gas field as their primary assets. Efforts to syndicate the loans have been unsuccessful due to the lack of fallback assets if the properties fail and market perception that the producers should have been sent to the high yield market. While pricing of the loans is favorable averaging LIBOR plus basis points, the bank is looking to reduce its exposure to this loan portfolio. Party B is a mid-size money management company who caught wind of the development of this new site in the Gulf and is keenly interested in the upside of the property.

One of the fund's managers is a close friend with the developer of the current generation of seismic imaging that discovered the gas field and thinks it will be a winner. Efforts to gain an equity stake in any of the small producers with rights to the field were rebuffed, which only served to solidify the manager's conviction that the property will succeed.

The fund manager wants exposure to these fields because he thinks the high rate of return the market is pricing into these credits is unjustified. He is looking to tap into the bank's loan portfolio but is prohibited from taking actual loans into the fund portfolio via syndication.

Credit Derivatives: Instruments, Applications, and Pricing

He is also looking to leverage up his exposure to the field if possible. This return will be a function of interest earned on previously distributed loans, future drawdowns of revolving credit agreements and default losses. Exhibit 3 illustrates these cash flows. The fund manager who is looking for maximum returns will likely opt for the leveraged position in this instance. The pricing is fairly simple since the spread on the loan portfolio has been established already, the dealer must only factor in the cost of administering the portfolio and his desired return on the swap to arrive at rate on the TRS.

Hedging is not a real issue in this case because the swap from the bank's perspective is reducing credit risk on the loan portfolio and adding credit risk to the fund company. As such, the trade is a form of risk diversification. For the fund manager the situation is much the same: he is gaining access to a credit exposure that he wants and will likely not hedge the position. If hedging were desired on his part, his alternatives would be limited since there are no publicly traded securities of any of the companies in the loan portfolio.

This would remove any replication strategies that are commonly used by dealers running hedged books in these markets.


Once the trade is booked, what are some of the system implications for Party A who has now swapped out of some of their loan portfolio risk and added a TRS to its books? Together, the cash flows and default percentages will determine the payouts to the trust and to the fund.

FRM: Credit default swap (version 2.0)

This creates the need for a system to track loans. What if the desk has other credit derivatives that it has hedged with short or long corporate bond positions or equity positions? The particulars of any credit derivative could have the credit derivatives desk relying on daily mark-to-market calculations from various groups in the bank. This can create control problems and make it difficult for the desk to mark their positions in a timely fashion. Reliance on disparate systems with different reporting methods is not ideal and is one of the challenges faced by innovators in this field.

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