LO 34.4: Describe the different types and structures o f credit derivatives including

LO 34.4: Describe the different types and structures o f credit derivatives including credit default swaps (C D S), first-to-default put, total return swaps (TRS), asset- backed credit-linked note (CLN ), and their applications.
One critique of traditional credit risk mitigation techniques is that they do not unbundle the credit risk from the underlying asset. Credit derivative products, such as credit default swaps, first-to-default puts, total return swaps, and asset-backed credit-linked notes, are over-the-counter financial contracts that respond directly to this critique. Payoffs for these instruments are contingent on changes in the credit performance or quality of a specific underlying issuer. Therefore, these tools directly enable one party to transfer the credit risk
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of a reference asset to another party without ever selling the asset itself. In doing so, credit derivative products also aid in price discovery aimed at isolating the economic value of default risk.
Consider an example of the usefulness of credit derivatives. Bank A specializes in lending to the airline industry, while Bank B specializes in lending to energy firms. When energy prices are high the energy firms tend to do well, while airlines languish. The reverse is true when energy prices are low. Bank A and Bank B could mitigate their credit risk by either directly selling 30% of their loans to each other, or they could use credit derivatives to more cost effectively meet the same need.
Investors and financial institutions can use credit derivatives to accomplish several different goals. Credit derivatives can provide access to specialized risk factors for both risk mitigation and for speculation. As previously mentioned, these credit products also unbundle credit risk from ownership of an underlying asset, effectively creating two unique tradable assets. Credit derivatives also provide yield enhancement and a mechanism to hedge industry- specific and country-specific risks borne by an investor or institution. Hedge funds, and other speculative investors, also use credit derivatives to exploit arbitrage opportunities.
Credit Default Swaps
The most popular form of credit derivative is the credit default swap (CDS). A CDS is customizable insurance against the default of some underlying asset. It is a de facto put option on the underlying asset. The protection buyer is trying to outsource credit risk, while the protection seller is actually buying credit risk by providing the insurance. Think of the protection buyer like a put buyer and the protection seller like a put seller. The protection buyer will make pre-specified payments to the protection seller over a pre-specified time period and the protection seller is liable for making the protection buyer whole if a credit event occurs. Hence, a single-name CDS operates essentially as an insurance contract but a key difference is that the protection buyer need not actually own the underlying asset. Figure 1 illustrates the mechanics of the single-name CDS.
Figure 1: CDS Structure
For example, if an institutional investor owned $100 million of a certain companys debt and wanted to protect himself from a potential default, the investor could enter into a CDS contract with 130 basis points with quarterly payments. That means that the investor would pay $375,000 [(1.5% x $100,000,000) / 4] every quarter for the length of the contract. The length of a CDS contract is usually much less than the duration of the underlying asset. If this debt instrument matured in 15 years, then the CDS contract might have a 23 year tenure. If this debt issuance has a yield of 4.5% then this protection buyer has enabled a 3.0% annual return without any default risk for the tenure of the CDS contract.
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Professors Note: According to the Bank for International Settlements (BIS), credit default swaps were virtually non-existent in 1997, ballooned to $62.2 trillion in 2007, and subsequently fell to approximately $16 trillion of notional value by the end o f 2014.
Why would an investor pay for credit default protection using a CDS contract? Obviously, they are concerned about a negative credit event impacting the value of the underlying asset. Payment to the protection buyer is triggered with several potential credit events. The first potential trigger event is bankruptcy. Payment can also be triggered by a specified drop in the value of the underlying asset that does not include bankruptcy. Downgrade below a certain threshold and unfavorable debt restructure can also result in a payment. The International Swaps and Derivatives Association (ISDA) has the final say on whether a credit event has officially triggered a CDS payment.
If a payment is triggered, the payment could be made in one of three ways. The first payment option is the par value of the underlying asset minus the post-default price. This is essentially a make me whole payment. The second payment option is par value minus a stipulated recovery factor. Most corporate bonds have a contractually stipulated 40% recovery rate. This means that the CDS was priced so that the most that a protection buyer could recover is 60% of the notional principal. The third payment option is the full payment of the par value, without any subtractions, but the protection buyer must also physically deliver the underlying asset to the protection seller. This is also a make me whole payment.
Credit default swaps can be used for risk management, but they can also be used for direct speculation. During the months and years leading up to the 20072009 financial crisis, some savvy investors who saw trouble on the horizon purchased CDS contracts against the default of various companies. In this way, these investors were using CDS contracts to replicate put options. However, the CDS contract is only as good as the creditworthiness of the counterparty. This risk should be considered as well. Lehman Brothers and American International Group (AIG) were two significant counterparties that did not weather the financial crisis very well.
First-to-Default Puts
A variation of the CDS is known as a first-to-default put. To explain this innovation, it will be easiest to consider a bank that holds four different B-rated high yield loans. Each loan has notional principal of $100 million, a five-year maturity, and an annual coupon of LIBOR plus 250 basis points. The idea is that this pool of loans has very low default correlations. The bank could purchase a first-to-default put for two years at perhaps 400 basis points. This means that the bank would pay $4 million annually for two years. In return for this insurance premium, the bank would be made whole in the event that any one of the four bonds defaulted. If two bonds default, then they still are only paid for the first bond and the second becomes a loss event. This is a much more cost effective option for the bank if the loans truly have uncorrelated default risks. The cost of the first-to-default put will lie between the cost of a CDS on the riskiest bond and the total cost for a CDS on all bonds.
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Total Return Swaps
While a CDS contract outsources only the credit risk, a total return swap (TRS) outsources both credit risk and market risk. A TRS is designed to mirror the return on an underlying investment, such as a loan, a floating rate note, a coupon bond, a stock, or a basket of assets. There are two parties to a TRS contract. The payer is the owner of the underlying asset. The payer will agree to pay the underlying assets total return, including any price appreciation and coupon or dividend payments, to a receiver. The receiver is responsible to pay the payer for any depreciation in the asset. The receiver will also pay LIBOR plus a predetermined spread to the payer regardless of what happens with the reference asset.
Figure 2: Total Return Swap Structure
LIBOR +/- Spread + price depreciation
In essence, the receiver is taking a synthetic long position in the underlying asset without actually owning the underlying. Tremendous leverage can be applied by the receiver because they do not need to invest the notional principal. They only need enough money to make payments when due. Hedge funds are one common receiver counterparty in TRS contracts. Banks are usually the payer counterparties because they have access to capital to purchase the underlying assets but are looking to remove credit and market risk exposure from their balance sheets.
Asset-Backed Credit-Linked Notes
A further innovation called an asset-backed credit-linked note (CLN) embeds a default swap into a debt issuance. A CLN is a debt instrument with its coupon and principal risk tied to an underlying debt instrument, like a bond, a loan, or a government obligation. Unlike a CDS contract, principal is exchanged when a CLN is sold to an investor, although the CLN seller retains ownership of the underlying debt instrument.
A CLN is best understood with an example. Assume there is a hedge fund that wants to capture $123 million of exposure to a fixed income instrument, but it only wants to invest $25 million as collateral. A bank agrees to help in the process. The bank will borrow $123 million at LIBOR and purchase the reference asset, which is currently yielding LIBOR plus 250 basis points. The reference asset is placed in a trust, which then issues a CLN to the hedge fund. The hedge fund will then give the bank $25 million, which is invested in a risk- free U.S. government obligation yielding 4%. This investment now represents the collateral
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on the banks borrowing. That means there is 20% ($23 million / $ 123 million) of collateral and a leverage multiple for the hedge fund of 5 times ($125 million / $25 million).
Remember that the reference asset is yielding LIBOR plus 250 basis points. The bank will keep LIBOR plus 100 basis points, using the LIBOR return to fund the cost of acquiring the reference asset and the additional 100 basis points as compensation for assuming the risk of default above the collateral of $25 million. The hedge fund will receive the 4% earned on the $25 million of collateral ($ 1 million) and will also receive the additional 150 basis point spread over the funding cost on the full $125 million ($1,875 million in additional return). This means that the hedge fund has captured an 11.5% leveraged return [($1 million + $1,875 million)/$25 million initial investment]!
There are no margin calls with a CLN, but there is still risk on the table for the hedge fund and for the bank. Should the reference asset lose more value than the $25 million in collateral, the hedge fund will default on its CLN obligation and lose the full $25 million investment. The bank will be responsible for any losses greater than the $25 million of hedge fund collateral. Thus, the bank will likely look to outsource this risk using a CDS contract.
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