Before we dwell into the intricacies of credit derivatives let’s first understand what the term credit risk means because credit derivatives are designed to mitigate the credit risk.
CREDIT RISK:
Credit risk is the probability that a debtor will not repay its financial obligation; it could be interest or principal. So the risk associated with non-payment of financial obligation is termed as credit risk. Credit risk mainly increases in the period of economic contraction and recession wherein more and more borrower start defaulting on their loans like what we have seen in the current scenario. A measure of credit risk of a company is its credit rating which is assigned by credit rating agencies like Moody’s and S&P etc. Quantitatively credit risk is measured by credit risk premium, which is difference between the interest rate a borrower has to pay and the interest rate on a risk free security. Generally the parties affected by credit risk are:-
Borrowers - there cost of borrowing depends upon their default risk,
Investors - as the credit rating of bond is downgraded it will increase the bond’s risk premium and hence will reduce the value of the bond,
Banks – they are directly exposed to default risk.
MANAGING CREDIT RISK:
There are mainly three ways of managing credit risk,
First is better underwriting and diversification of credit portfolio which means underwriting only those loans in which borrower has a sound credit history and has the capability to repay the loan and diversification means to diversify the loans across geographies and industries.
Second way of managing credit risk is Securitization, in which similar type of bonds or loans with credit risk are pooled together into a single package and then and sold in pieces to outside investors which are mainly big financial institutions, institutional investors and pension funds etc. These securities are called asset backed securities (ABS) as they are collateralized by an underlying pool of loans or bonds. This kind of arrangement is favorable to both FI, as diversification across different loans reduces their credit risk, and banks as they have transferred their credit risk to investors and hence carries minimal credit risk.
Third way of managing credit risk is Credit derivatives, they provides insurance against credit related loses. Credit derivatives could be defined as financial contract in which two parties exchange payments in which one leg of the payment is dependent on the ‘performance’ of specified underlying.
For example let’s take case of life insurance in which insurer and insured exchange payments but in that case one leg of payment is dependent on ‘performance’ or for that matter happening of a particular event say theft or damage (in case of vehicle insurance). Similarly in case of credit derivatives one bank takes premium from another bank and give the first bank insurance against the losses that it might suffer if a ‘credit event’ occurs which can be default on a loan or downgrading of credit rating of the company.
CREDIT DERIVATIVES:
Credit Derivatives are of different types, we will discuss each one of them separately.
Swaps:
(a) Total Return Swap: It is a swap agreement in which total return of a bank loan or some other credit sensitive security is exchanged for some other fixed cash flow which is generally tied to LIBOR. In this way it act as a instrument to transfer risk from the party who didn’t have risk appetite to the party who is willing to take risk on account of higher return.
For example consider a bank A who is not willing to hold a loan in its portfolio as the interest rates are highly volatile and there is no fixed income that is generated out of this loan or bank consider the loan to very risky, so bank A enters into a contract with bank B in which bank B pays bank A fixed amount say ‘LIBOR + x%’ every month and in lieu of that bank B keeps the installment that borrower is paying.
(b) Credit Default Swap: A default swap is an agreement in which a periodic fixed-rate payment is exchanged for the promise of some specified payment(s) to be made in case a predefined ‘credit event’ occurs. A credit event could be anything which is mutually agreed by both the parties. A typical credit event would be a default or a credit downgrade.
For example let’s consider bank A and bank B in which bank A (protection buyer) is paying the fixed rate payment to bank B (protection seller) and if a credit event occurs in that case bank B will make the contingent payment to bank A. The contingent payment to be paid by the bank B is effected by the cash settlement mechanism which is designed to mirror the losses incurred by the bank A. This contingent payment is calculated based on the fall in price of the reference obligation below par, in our case we can say that bank B will cover all the losses incurred by bank A due to less payment by the reference entity to bank A. Sometimes contingent payment is fixed at predetermined percentage of par value; this is known as ‘binary’ settlement. Let’s consider the above mentioned example again for understanding binary settlement, in this case if reference entity fails or makes less payment to bank A then in that case bank B will make predetermined fixed amount of payment to bank B irrespective of the amount less paid by the reference entity. Say predetermined fixed amount was Rs 1000 on a loan of Rs 10,000 then if reference entity pays Rs 10 less or Rs 5000 less, bank B will pay Rs 1000 to bank A.
Credit-Linked Notes:
A credit linked note is a combination of a regular bond and a credit derivative. It is used by borrowers to hedge against credit risk and by investors to have higher returns on their fixed income portfolio. A credit linked note is like a simple bond which make periodic interest payment but in case of credit linked note repayment of principal is dependent upon ‘credit event’, if a predefined credit event occurs then borrowers can reduce the principal amount. The redemption value of credit linked note is directly dependent on the redemption value of underlying asset.
Let’s take the example of a credit card company which issues credit linked note to reduce its company’s credit risk exposure and it agrees to pay investors an interest of 13%, then it would continually pay interest payment to its investors but principal repayment will depend upon the number of credit defaults (credit event in this case). So if lesser number of defaults happens then company would be able to pay principal in full, but if the default rate is higher than company would only have to pay part of the principal.
Credit Options:
Credit options allow investors to protect themselves against adverse moves in the quality of financial assets. They are used to transfer risk from the person who didn’t have appetite for it to the person who is willing to take the risk. It’s actually like car insurance, you keep paying insurance premium and if your car is stolen or damaged you have the cover and insurance company will pay the damages but in case car is not damaged owner receives nothing. Thus insurance company by charging a fee is giving a protection against large financial loss.
Let’s consider a example where in a home buyer buys a call option on his home loan say spot interest rate is 9% and he buys a call option with strike interest rate of 10% and for that he pays a option premium to the party/bank to whom with he has entered into the contract now if interest rate moves beyond 10% then he will get offsetting amount from the bank but in case if interest don’t moves beyond 10% then he will not receive any payment, this in a way would increase his total amount that he is paying monthly (installment + option premium). One way to take care of this extra premium is to sell put option on the same loan, as spot rate is 9% then this investor would sell put option with strike interest rate of 8% and he will receive the option premium on the same but in a case if interest rate moves below 8% then too he will have to pay interest rate of 8%. In this way actually investor creates a band of interest rate for himself without increasing his total burden.
Credit derivatives are broadly divided into two categories:
(a) Standard Credit Options: They are simple derivatives which gives option buyer the right, but not the obligation, to buy(call) or sell(put) an asset at a pre-decided price (strike price) for a specified period of time (expiry).
(b) Exotic Credit Options: They are those credit options which break at least one of the rules of standard option with respect to time, price, position or underlying asset. Generally they are classified into two forms:
(i) Barrier Credit Option: They are like a trigger that turns the option ‘on’ or ‘off’ which is dependent upon the credit quality of the underlying asset. Consider a ‘down and out’ call which is similar to the call option explained above but only difference is if say interest rate moves from 9% to 8% (barrier level) for instance, then option would become null and void. Barrier credit options are:
Up-and-out: Spot price starts below the barrier level and has to move up for the option to be knocked out.
Down-and-out: Spot price starts above the barrier level and has to move down for the option to become null and void (as explained above).
Up-and-in: Spot price starts below the barrier level and has to move up for the option to become activated.
Down-and-in: Spot price starts above the barrier level and has to move down for the option to become activated.
(ii) Digital Credit Option: They are also referred as Binary credit options. They have a payout of either zero if the option expires out of the money, or some predetermined payment if option expires in the money. Fixed payment, unlike a standard option is independent of how deep in the money the option actually is or of current market price of the underlying asset
Advantages of Credit Derivatives:
(a) When one bank is hedging itself against credit risk then reference entity whose credit risk is transferred need not to be involved or aware of the transaction. This confidentiality helps bank to manage credit risk without interfering with important customer relationships.
(b) With the absence of reference entity credit derivatives can be highly customized such as term, size, structure etc. could be described by the parties entering into contract according to their requirements.
(c) With increased use of these instruments by large financial institutions liquidity and pricing technology have also improved over the time and with the use of credit derivatives credit spread forward curves and implied volatilities could be defined in much better way than less liquid credit products could have ever done.
(d) Credit derivatives are an off balance sheet item unless embedded in structured notes. So it gives flexibility to the user to define their degree of leverage in a credit investment. This helps hedge fund in both synthetically finance the position and avoid the administrative cost of directly owning the asset (which is borne by swap counterparty which is generally a bank).
(e) Credit derivatives makes feasible to take the positions in credit products without owning them like a financial institution which directly has no loan in its portfolio can enter into a swap agreement with bank and hence let them take the positions without having to follow the regulations that banks are required to follow while disbursing loans like reserve requirements etc.
(f) Financial intermediaries can take advantage of the arbitrage opportunities; globally credit markets display discrepancies in pricing of same credit risk across different asset classes, maturities, time zones and currencies. With improved liquidity of credit derivatives it becomes easier for market makers to take advantage of such arbitrage opportunities which will ultimately help credit markets to become more efficient.
While I have tried to cover majorly all the basic concepts related to credit derivatives but there is lot more in credit derivatives which includes several complex and new credit derivatives structures and models which are developed by financial engineers of big investment banks which help them mitigate their credit risk and sometimes help them to take highly leveraged positions with high risk and very high returns. There is lot which can be discussed about the risk and modeling of credit derivatives, one of the most basic and severe risk in credit derivatives is the counterparty risk.
For example a bank A might be in credit default swap contract with another bank B for which it will pay premium to bank B, but it might happen in case of default by the reference entity bank B doesn’t owner its contract of paying bank A the insured amount, in simple words bank B also defaults then bank A will have to deal with double losses i.e. loss due to nonpayment (default) by reference entity and second is because of default by bank B(premium loss) such kind of risk is known as counterparty risk.
Moreover there is no organized market for credit derivatives and most of the trading happens on OTC (Over the Counter) market. They are highly customized according to the requirements of both the parties which are entering into the contract which makes these products highly illiquid. As there is no intermediary (regulator) and clearing house involved so it makes these products more risky to deal in.
Other things which I was not able to cover in the article were the valuation of these derivatives which includes calculating premium amount for CDS and for other credit options (Standard and exotic) and how the fixed rate is decided in case of TRS on which risk seller will make the fixed payment to risk buyer. Similarly there are many payoff structures which can be constructed using these complex instruments which are really difficult to cover in a single article.
