Understanding Credit Derivatives

Overview of Risk existing in the market

Risk is the uncertainty in any transaction. Risk may manifest itself in multiple forms including market risk, credit risk, operational risk, compliance risk etc. Over the years, banks and financial institutions have become risk aware which is evident from the increased investment towards strengthening of their overall risk management infrastructure. Out of the aforesaid types of risks, Credit Risk happens to be a risk which banks and lending institutions monitor very closely.

In simple terms, credit risk explains the probability of loss on a trade due to the counterparty’s failure to meet their side of a contractual obligation. For instance, assume two parties namely A and B had entered an interest rate swap contract which is a popular derivative product. Let’s assume party A has run into financial problems and is unable to fulfil its obligations, then it may default either in part OR in full on its payment commitments that are due to party B. Therefore, party B is exposed to potential losses on this trade. This is a simple example to understand credit risk.

Let’s extend this analysis to the Over the Counter (OTC) market. OTC market is huge with contracts worth trillions of dollars of notional amounts that are outstanding on the trading books of market participants. This exposes participants to a significant amount of credit risk. Further, as observed during the GFC, there is honestly no one that was “too big to fail”. Hence, credit risk management is vital for the long-term well-being of an Institution.

Market participants look at a variety of approaches to mitigate the credit risk. There are a variety of ways to manage/hedge the credit risk on their portfolio. In this article, we will understand a few types of credit derivative products that are frequently used by market participants to transfer the credit risk away from their books.

What is a credit derivative?

Credit Derivative is defined as a product whose payoff is contingent upon the changes in the credit performance / credit quality of a certain underlying product / issue/ issuer.

Credit derivatives allow transfer of credit risk onto a counterparty. As you must have guessed, no counterparty will accept additional risk without getting compensated for it. Therefore, as a part of credit derivative trade, the party that is selling/transferring risk away (i.e., the protection buyer) from itself to its counterparty (i.e., protection seller), is expected to pay a premium. In return, the counterparty provides protection against potential credit risk. Therefore, to understand the basic idea of a credit derivative trade:

Protection Buyer: Sells credit risk (i.e., buys credit protection) and makes premium payment to the protection seller.

Protection Seller: Buys credit risk (i.e., sells credit protection) and receives premium payment from the protection buyer with a commitment to protect the buyer from losses arising from a credit default.

Types of Credit Derivatives:

There is a large variety of credit derivatives that trade in the market. In this article we discuss a few popular ones. Credit derivatives are highly quantitative in nature and incorporate numerous concepts from the domain of mathematical finance. However, for the benefit of a broad variety of audience, I have deliberately skipped the intricate mathematical concepts that surround these products. I will attempt to explain the structure & functioning of these products in plain English!

For each of the credit derivatives below, I will present a block diagram and describe the structure so that it becomes easy to understand.

1. Credit Default Swap (CDS)

For the CDS contract, there are two parties as mentioned in the earlier sections. Namely, the protection buyer and protection seller. Lets understand the cash flow scheme under the CDS.

Credit Default Swap

o Protection Buyer: Makes a periodic payment to the seller (generally a specific percentage of the notional) UNTIL a default / credit event occurs. This periodic payment is called as the premium paid by the buyer.

o Protection Seller: Makes payment ONLY when a default / a credit event occurs. Seller continues to receive premium payments from the buyer until a pre-agreed credit event occurs.

o After occurrence of default / credit event:

a. Generally, its Par Value — Recovery Rate on the underlying

b. RR is generally assumed 40% — bonds and 60% — bank loans

What are Credit Events?

Credit event is defined as a set of pre-defined events that are tantamount to credit default. The list of credit events are known beforehand and are agreed by the CDS counterparties at the time of entering into the contract. A list of popular credit events are enlisted below:

o Default / partial default

o Bankruptcy

o Credit downgrade

o Restructuring

o If price of the underlying falls below a threshold

o Unwillingness by the bond issuer to make periodic payments on the bond

o Issuer being legally prohibited from making payments

How exactly do we decide on the payment that is to be made at default/credit event occurrence?

The settlement under CDS could be cash settlement or physical settlement by delivery of the underlying to the seller.

The quantum of payment could be done by either of the following:

o Through Dealer Poll: Par Value of the asset — Post default price of the asset

o Par Price + recovery factor (pre-decided)

o Seller Pays à Par AND Buyer à Delivers underlying asset to seller

It should be noted that in a CDS contract, only the credit risk is transferred from buyer to seller

2. First to Default Put

Banks may be holding a portfolio of loans on their books. If the bank decides to hedge every single loan on its book, it may get very expensive. Therefore, to mitigate credit risk at the same time keep the costs low, banks may want to use the First to Default Put.

First to Default Put

This product, provides a hedge against the first loan in the portfolio defaulting

1. Bank purchases this product on a loan book (i.e., banking book).
2. If One/more loans default at anytime before contract maturity à Bank gets paid for the first loan defaulted

Banks/lending institutions attempt to diversify their loan portfolio so that the correlation between the loans comes down. The lower the correlation of the loans on the book, the better diversified is the loan portfolio.

Assuming default events are un-correlated:

1. Counterparty selling this product will need to compensate bank by: Par Value X PD
2. Assuming PD of each loan out of a 4 loan book is 1%, then the PD of the loan portfolio is 1% X 4 X $100 mio = $4 mio

Yield on First to Default Put is a function of:

1. Number of loans in the portfolio
2. Expected correlation between loans

3. Total Return Swap (TRS)

Total Return Swap will attempt to replicate the performance of the underlying asset. Underlying could be a host of products including loans, bonds, etc.

As it’s a swap transaction, it makes sense to review the cash flows on this product to understand this better:

Typical cash flows on TRS:

• Buyer pays à Libor/Floating benchmark + pre-decided spread
• Seller pays à Some form of a total return on the underlying asset

At maturity:

If P(0) is the initial asset price; P(T) is the market price of the asset at time “T”

a. Buyer gets paid P(T) — P(0) if P(T) — P(0) > 0

b. Buyer pays P(0) — P(T) otherwise

c. In physical settlement: Buyer take delivery of the underlying, by paying P(0) to seller

In this article we have discussed 3 types of credit derivatives. There are a lot of other types of credit derivatives And credit risk mitigation procedures that market participants frequently use. From a risk management perspective, this is a very important product as it helps the risk manager contain the risk from potential credit defaults by counterparties. Further, from a trading perspective as well these products are actively used by front offices in banks to build trading positions.

Regulatory organizations also monitor the credit derivatives market closely as it gives further insights into the health of the credit market in the broader economy. For example, post the GFC, there have been a numerous number of regulatory changes that have impacted to the way the credit derivatives market functions. For instance, the notable one being the “big bank reforms” pertaining to CDS that resulted in standardizing the way CDS contracts are structured and traded by the market participants.

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