Description
credit derivatives which includes credit default swaps, binary CDS, total return swap, collaterized debt obligation. It also explains synthetic CDO structure based on CDS.
Credit Derivatives
1
Credit Default Swaps
• Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity). • Buyer pays a premium of 90 bps per year. Premium is known as the credit default spread. It is paid for life of contract or until default. • If there is a default, the buyer gets compensated for the default value. That is, the buyer gets the difference between the face value of the bond and the recovery value per bond from the seller.
2
CDS Structure (Figure 23.1)
90 bps per year Default Protection Buyer, A Default Protection Seller, B
Payoff if there is a default by reference entity=100(1-R)
Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond.
3
Other Details
• Payments are usually made quarterly in arrears. • In the event of default, there is a final accrual payment by the buyer. • Settlement can be specified as delivery of the bonds or in cash.
4
Attractions of the CDS Market
• Allows credit risks to be traded in the same way as market risks. • Can be used to transfer credit risks to a third party. • Can be used to diversify credit risks.
5
Using a CDS to Hedge a Bond
Portfolio consisting of a 5-year par yield corporate bond that provides a yield of 6% and a long position in a 5-year CDS costing 100 basis points per year results into a long position in a riskless instrument paying 5% per year.
6
Valuation Example
• Conditional on no earlier default, a reference entity has a (risk-neutral) probability of default of 2% in each of the next 5 years. (This is a default intensity.) • Assume payments are made annually in arrears; that defaults always happen half way through a year; and that the expected recovery rate is 40%.
• Suppose that the breakeven CDS rate is s per dollar of notional principal.
7
Unconditional Default and Survival Probabilities (Table 23.1)
Time (years) 1 2 Default Probability 0.0200 0.0196 Survival Probability 0.9800 0.9604
3
4 5
0.0192
0.0188 0.0184
0.9412
0.9224 0.9039
8
Calculation of PV of Payments
Table 23.2 (Principal=$1)
Time (yrs) 1 2 3 4 5 Total Survival Expected Discount PV of Prob Paymt Factor Exp Pmt 0.9800 0.9800s 0.9512 0.9322s 0.9604 0.9604s 0.9048 0.8690s 0.9412 0.9412s 0.8607 0.8101s 0.9224 0.9224s 0.8187 0.7552s 0.9039 0.9039s 0.7788 0.7040s 4.0704s
9
Present Value of Expected Payoff (Table 23.3; Principal = $1)
Time (yrs) 0.5 1.5 2.5 3.5 4.5 Total Default Prob. 0.0200 0.0196 0.0192 0.0188 0.0184 Rec. Expected Discount PV of Exp. Rate Payoff Factor Payoff 0.4 0.4 0.4 0.4 0.4 0.0120 0.0118 0.0115 0.0113 0.0111 0.9753 0.9277 0.8825 0.8395 0.7985 0.0117 0.0109 0.0102 0.0095 0.0088 0.0511
10
PV of Accrual Payment Made in Event of a Default. (Table 23.4; Principal = $1)
Time 0.5 1.5 2.5 3.5 4.5 Default Prob. 0.0200 0.0196 0.0192 0.0188 0.0184 Expected Accr. Pmt. 0.0100s 0.0098s 0.0096s 0.0094s 0.0092s Disc Factor 0.9753 0.9277 0.8825 0.8395 0.7985 PV of Pmt. 0.0097s 0.0091s 0.0085s 0.0079s 0.0074s
Total
0.0426s
11
Putting it all together
• PV of expected payments is 4.0704s+0.0426s = 4.1130s • The breakeven CDS spread is given by 4.1130s = 0.0511 or s = 0.0124 (124 bps) • The value of a swap negotiated some time ago with a CDS spread of 150bps would be 4.1130×0.0150?0.0511 or 0.0106 times the principal to the seller of CDS.
12
Other Credit Derivatives
• Binary CDS • Total return swap • Collateralized debt obligation
13
Total Return Swap
• Agreement to exchange total return on a portfolio of assets for LIBOR plus a spread. • At the end there is a payment reflecting the change in value of the assets. • Usually used as financing tools by companies that want an investment in the assets.
Total Return Payer
Total Return on Assets LIBOR plus 25bps
Total Return Receiver
14
Asset Backed Securities (ABS)
• Security created from a portfolio of loans, bonds, credit card receivables, mortgages, auto loans, aircraft leases, music royalties, etc. • Usually the income from the assets is tranched. • A “waterfall” defines how income is first used to pay the promised return to the senior tranche, then to the next most senior tranche, and so on.
15
Possible Structure of ABS (Figure 23.3)
Asset 1 Asset 2 Asset 3 ? Tranche 1 (equity) Principal=$5 million Yield = 30%
SPV
Tranche 2 (mezzanine) Principal=$20 million Yield = 10%
Tranche 3 (super senior) Principal=$75 million Yield = 6%
Asset n Principal=$100 million
16
The Credit Crunch out of CDOs
(see Business Snapshot 23.4)
• Between 2000 and 2006 mortgage lenders in the U.S. relaxed standards (liar loans, NINJAs, ARMs) • Interest rates were low • Demand for mortgages increased fast • Mortgages were securitized using ABSs and ABS CDOs • In 2007 the bubble burst • House prices started decreasing. Defaults and
17
Synthetic CDO Structure based on CDS
CDS 1 CDS 2 CDS 3
Tranche 1: 5% of principal Responsible for losses between 0% and 5% Earns 1500 bps Tranche 2: 10% of principal Responsible for losses between 5% and 15% Earns 200 bps Tranche 3: 10% of principal Responsible for losses between 15% and 25% Earns 40 bps
?
CDS n
Trust
Average Yield 8.5%
Tranche 4: 75% of principal Responsible for losses between 25% and 75% Earns 10bps
18
Synthetic CDO Details
• The bps of income is paid on the remaining tranche principal. • Example: when losses have reached 7% of the principal underlying the CDSs, tranche 1 has been wiped out, tranche 2 earns the promised spread (200 basis points) on 80% of its principal
19
doc_736018393.pptx
credit derivatives which includes credit default swaps, binary CDS, total return swap, collaterized debt obligation. It also explains synthetic CDO structure based on CDS.
Credit Derivatives
1
Credit Default Swaps
• Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity). • Buyer pays a premium of 90 bps per year. Premium is known as the credit default spread. It is paid for life of contract or until default. • If there is a default, the buyer gets compensated for the default value. That is, the buyer gets the difference between the face value of the bond and the recovery value per bond from the seller.
2
CDS Structure (Figure 23.1)
90 bps per year Default Protection Buyer, A Default Protection Seller, B
Payoff if there is a default by reference entity=100(1-R)
Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond.
3
Other Details
• Payments are usually made quarterly in arrears. • In the event of default, there is a final accrual payment by the buyer. • Settlement can be specified as delivery of the bonds or in cash.
4
Attractions of the CDS Market
• Allows credit risks to be traded in the same way as market risks. • Can be used to transfer credit risks to a third party. • Can be used to diversify credit risks.
5
Using a CDS to Hedge a Bond
Portfolio consisting of a 5-year par yield corporate bond that provides a yield of 6% and a long position in a 5-year CDS costing 100 basis points per year results into a long position in a riskless instrument paying 5% per year.
6
Valuation Example
• Conditional on no earlier default, a reference entity has a (risk-neutral) probability of default of 2% in each of the next 5 years. (This is a default intensity.) • Assume payments are made annually in arrears; that defaults always happen half way through a year; and that the expected recovery rate is 40%.
• Suppose that the breakeven CDS rate is s per dollar of notional principal.
7
Unconditional Default and Survival Probabilities (Table 23.1)
Time (years) 1 2 Default Probability 0.0200 0.0196 Survival Probability 0.9800 0.9604
3
4 5
0.0192
0.0188 0.0184
0.9412
0.9224 0.9039
8
Calculation of PV of Payments
Table 23.2 (Principal=$1)
Time (yrs) 1 2 3 4 5 Total Survival Expected Discount PV of Prob Paymt Factor Exp Pmt 0.9800 0.9800s 0.9512 0.9322s 0.9604 0.9604s 0.9048 0.8690s 0.9412 0.9412s 0.8607 0.8101s 0.9224 0.9224s 0.8187 0.7552s 0.9039 0.9039s 0.7788 0.7040s 4.0704s
9
Present Value of Expected Payoff (Table 23.3; Principal = $1)
Time (yrs) 0.5 1.5 2.5 3.5 4.5 Total Default Prob. 0.0200 0.0196 0.0192 0.0188 0.0184 Rec. Expected Discount PV of Exp. Rate Payoff Factor Payoff 0.4 0.4 0.4 0.4 0.4 0.0120 0.0118 0.0115 0.0113 0.0111 0.9753 0.9277 0.8825 0.8395 0.7985 0.0117 0.0109 0.0102 0.0095 0.0088 0.0511
10
PV of Accrual Payment Made in Event of a Default. (Table 23.4; Principal = $1)
Time 0.5 1.5 2.5 3.5 4.5 Default Prob. 0.0200 0.0196 0.0192 0.0188 0.0184 Expected Accr. Pmt. 0.0100s 0.0098s 0.0096s 0.0094s 0.0092s Disc Factor 0.9753 0.9277 0.8825 0.8395 0.7985 PV of Pmt. 0.0097s 0.0091s 0.0085s 0.0079s 0.0074s
Total
0.0426s
11
Putting it all together
• PV of expected payments is 4.0704s+0.0426s = 4.1130s • The breakeven CDS spread is given by 4.1130s = 0.0511 or s = 0.0124 (124 bps) • The value of a swap negotiated some time ago with a CDS spread of 150bps would be 4.1130×0.0150?0.0511 or 0.0106 times the principal to the seller of CDS.
12
Other Credit Derivatives
• Binary CDS • Total return swap • Collateralized debt obligation
13
Total Return Swap
• Agreement to exchange total return on a portfolio of assets for LIBOR plus a spread. • At the end there is a payment reflecting the change in value of the assets. • Usually used as financing tools by companies that want an investment in the assets.
Total Return Payer
Total Return on Assets LIBOR plus 25bps
Total Return Receiver
14
Asset Backed Securities (ABS)
• Security created from a portfolio of loans, bonds, credit card receivables, mortgages, auto loans, aircraft leases, music royalties, etc. • Usually the income from the assets is tranched. • A “waterfall” defines how income is first used to pay the promised return to the senior tranche, then to the next most senior tranche, and so on.
15
Possible Structure of ABS (Figure 23.3)
Asset 1 Asset 2 Asset 3 ? Tranche 1 (equity) Principal=$5 million Yield = 30%
SPV
Tranche 2 (mezzanine) Principal=$20 million Yield = 10%
Tranche 3 (super senior) Principal=$75 million Yield = 6%
Asset n Principal=$100 million
16
The Credit Crunch out of CDOs
(see Business Snapshot 23.4)
• Between 2000 and 2006 mortgage lenders in the U.S. relaxed standards (liar loans, NINJAs, ARMs) • Interest rates were low • Demand for mortgages increased fast • Mortgages were securitized using ABSs and ABS CDOs • In 2007 the bubble burst • House prices started decreasing. Defaults and
17
Synthetic CDO Structure based on CDS
CDS 1 CDS 2 CDS 3
Tranche 1: 5% of principal Responsible for losses between 0% and 5% Earns 1500 bps Tranche 2: 10% of principal Responsible for losses between 5% and 15% Earns 200 bps Tranche 3: 10% of principal Responsible for losses between 15% and 25% Earns 40 bps
?
CDS n
Trust
Average Yield 8.5%
Tranche 4: 75% of principal Responsible for losses between 25% and 75% Earns 10bps
18
Synthetic CDO Details
• The bps of income is paid on the remaining tranche principal. • Example: when losses have reached 7% of the principal underlying the CDSs, tranche 1 has been wiped out, tranche 2 earns the promised spread (200 basis points) on 80% of its principal
19
doc_736018393.pptx