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Essay on Credit Derivatives (CDs)
Essay Contents:
- Essay on the Introduction to Credit Derivatives
- Essay on the Definition of Credit Derivatives
- Essay on the Forms of Credit Derivatives
- Essay on the Practical Applications of Credit Derivatives
- Essay on the Hedging Pitfalls in Practice of Credit Derivatives
- Essay on the Scope of Credit Derivatives in India
Essay # 1. Introduction to Credit Derivatives:
For most banks, particularly Indian banks, the single largest source of earnings and perhaps earnings volatility also are on account of credit risk. The traditional means to deal with credit risk include lending policies, credit approval processes, discretionary power structure, collateral and guarantees, concentration limits (with regard to single or group borrowers, industries or geographic regions), documentation, etc.
Credit derivatives provide banks with a tool to manage the risks in credit portfolio even without affecting the portfolio size or customer needs. It also helps managing portfolio characteristics of risk & return and prudential capital requirement. Globally Credit Derivatives (CDs) are increasingly being used by banks and financial institutions to effectively manage credit risks. It emerged as a financial instrument around 1993-94 and shot into popularity during 1997 Asian crisis when the US and European banks wanted to offload their exposure to Asian credits.
Essay # 2. Definition of Credit Derivatives:
A credit derivative is an over-the-counter bilateral contract between two or more counterparties that provide for transfer of risks in a credit asset or credit portfolio without necessarily transferring the underlying asset from the books of the originator.
Generally credit derivatives transfer risks in a credit asset without transferring the underlying asset themselves from the books of the originator. Hence, they are off-balance sheet financial instrument. All credit assets (loans, bonds, account receivable, financial leases, etc.) are bundles of risk and rewards. The risks include interest rate, currency, commodity or equity risks besides credit risk.
When credit risks from such assets are unbundled into a commodity and traded in the market separately they are regarded as credit derivatives. Credit insurance and letters of credit may be similar to credit derivatives, but they do not offer the same flexibility, liquidity and regulatory benefits. Only credit derivatives bridge the gaps between the loan, securities and derivatives markets, thus contributing to the liquidity of credit markets.
The mechanism of credit derivate can be explained as follow:
Under a CD transaction, Protection Buyer (PB, generally the Originator of credit assets) enter into an agreement with the Protection Seller (PS), whereby the PB transfers Credit Risks with reference to a ‘Notional Value’ of the Reference Obligation (credit asset) to the PS, by agreeing to pay regular Premiums to the PS.
In the instance of a Credit Event (delinquencies, default, foreclosure, prepayments, etc. as agreed upon in the contract) taking place with respect to the reference obligation, there is a Settlement between them, whereby the PS compensates the PB for the losses incurred as a result of the event.
The settlement can be ‘Physical Settlement’ or ‘Cash Settlement’. Under a physical settlement, the PB delivers the reference asset to the PS and in return the PS the par value plus accrued interest of the reference asset. In a cash settlement PS pays the PB the loss suffered (i.e., the difference between the par value plus accrued interest and the market value of the defaulted reference obligation or the estimated recoveries).
Credit Derivatives are generally Over-the-Counter (OTC) instruments. To avoid disputes arising from such instrument, international Swaps and Derivatives Association, Inc. (ISDA) has come out with a standardised format of documentation evidencing such transaction. ISDA has also defined Credit Events to include six events, namely – bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation/moratorium and restructuring.
Credit derivatives may take several forms. Widely used credit derivatives are Credit Default Swaps, Total Return Swaps, Credit-Linked Notes and Credit Spread Options.
The reasons for entering into credit derivatives are:
a. Motives for Protection Buyers:
i. Transferring credit risk without transferring the credit asset
ii. Hedging against credit risks
iii. Relief in regulatory capital required for credit assets which can be used for further business purpose
iv. Better portfolio management by reducing concentration in market, i.e., diversification.
b. Motives for Protection Sellers:
i. Yield Enhancement
ii. Speculation
iii. Arbitrage in case the credit derivative instruments are inefficiently priced
iv. Diversification of credit risk
v. Credit derivatives initially were used only for hedging. However, during the last few years, credit derivatives are increasingly being used for speculative purposes like any other derivative, viz., interest rate, equity and forex derivatives.
Essay # 3. Forms of Credit Derivatives (CDs):
i. Credit Default Swaps (CDs):
A Credit default swap is a transaction in which a credit hedger (PB) pays a periodic premium to an investor (PS) in return for protection against a credit event experienced on a reference obligation, (i.e. the underlying credit that is being hedged).
Credit events are ISDA defined credit events and include six events, namely – bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation/moratorium and restructuring.
Reference obligations can include debt securities and loans to entities such as corporations, banks and sovereigns. Common reference assets include senior and subordinated debts, syndicated or bilateral term loans and revolving credits and obligations documented under ISDA agreements.
Once a credit default swap has been transacted, there are two possible outcomes during the life of the transaction. The first is that the specified credit event does not occur, in which case the PB pays all required premiums and upon maturity the swap matures and there are no other cash flow. Alternatively, a credit event does occur, at which point the calculation agent generates a credit event notice and evidence of publicly available information and the PB is compensated by the investor either by way of Physical Settlement or Cash Settlement.
Physical settlement is more common where the PB hands over or assigns or sells the reference obligation PS in return for receiving the notional amount of the swap. Cash settlement involves the calculation agent determining the post-default cash value of the reference obligation. The difference between par and this price is used to calculate the cash settlement value. A hybrid of the cash settlement method is also possible.
ii. Total Return Swaps (TRS):
In a total return swap the PB swaps with the PS, total actual return (coupon capital appreciation/depreciation) on an asset in return for a premium. The premium is arrived at by adding a spread to a reference rate like LIBOR. Thus in a TRS, protection seller is able to synthetically create an exposure to the reference asset without actually lending to it.
A total return swap represents an off-balance sheet replication of a financial asset such as a loan or bond. Whereas credit default swaps capture only credit risk, total return swaps involved the transfer of the total economic return of the asset (i.e., both credit and market risks.)
Most total return swaps provide for the payment of the total return of an asset versus payment of a variable rate of interest (such as Libor) plus or minus a pre-determined spread. The total return can be measured in arrears as the total accrued cash flows (i.e., accrued interest, coupons, amortisation and pre-payments) plus the price change of the reference obligation during the swap tenor. The reasons for entering into total return swaps are quite different to those associated with credit default swaps.
For PBs, they provide a complete economic hedge and capture even modest reductions in the price of an asset due to market or credit quality changes, unlike credit default swaps. Total return swap reference obligations include many of the same reference obligations as credit default swaps, but lend themselves particularly well to hedging the credit and market risks of amortisation, pre-payable and fixed rate assets.
iii. Credit Linked Notes (CLN):
CDS are generally off-balance sheet items and are not funded exposure. CLNs are on balance sheet equivalents of a CDS which combines credit derivative to normal bond instruments. It thus converts credit derivatives (generally an OTC instrument) into a capital market instrument.
A credit linked note is simply a securitised form of a credit default swap. In other words, they are debt instrument with an embedded credit derivative. The credit risk delivered to a credit linked note investor is a dual risk that of the credit linked note issuer (normally highly rated) and the reference obligation of the embedded credit derivative.
Like credit default swaps, credit linked notes pay an enhanced coupon and mature as scheduled unless a credit event occurs. If such a credit event does occur, the credit linked note will typically be redeemed by the issuer at a price linked to the value of the reference obligation.
From a dealer perspective, credit linked notes are simply an alternative product delivery vehicle. Unlike credit default swaps and total return swaps, CLNs allow the risk to be distributed to a much boarder market of investors. Credit-linked notes provide transaction opportunities with clients to whom credit lines are limited or unavailable. Finally, they may also provide the PBs with preferential capital treatment due to the high credit quality of collateralised transactions.
iv. Credit Spread Options:
Credit Spread options enable credit hedgers to acquire protection from an unfavourable migration or Credit spread risk of an asset, as measured by a widening of its credit spread. Credit spread options transfer credit spread risk from the credit spread PB to an investor (PS), in return for an upfront or periodic payment of premium.
Credit spread options may be for a specified period exercisable in American or European style at a preset strike quoted in cash price or Libor spread terms. The option may be cash settled or physically settled into an asset swap.
4. Practical Applications of Credit Derivatives:
Example 1:
Hedging loan concentrations; imagine that a bank has a long standing relationship with a borrower. The borrower has requested a term loan for Rs 100 Crores for a period of 5 years for setting up a sponge iron plant. The bank cannot extend the loan because the new exposure would exceed bank limits set for iron and steel exposure.
Solution:
The bank can extend the loan and arrange a total return swap with a hedge fund investor. The total return of the loan, paid on a periodic basis, includes all fees, interest received, amortization and any pre-payments. The bank would receive a spread over 5 year Government of India security such that it covers cost of funds, transaction costs and some profit margin.
The advantages of this approach include:
i. Retains its customer,
ii. Hedges the risk of the loan, and
iii. Reduces the amount of regulatory capital.
Example 2:
Transferring default risks; imagine that an A-rated oil company is planning to arrange a fully drawn one-year credit for Rs 1,600 Crores and has invited few banks into the deal. The company requested the bank to commit Rs 600 Crores but the bank’s credit portfolio management team has placed a limit of Rs 200 Crores as they are concerned about the bank’s significant exposure to the oil company.
Solution:
The bank can commit to the request and arrange a credit default swap with another bank for Rs 400 Crores. The bank can approach foreign or regional banks that are at a credit risk origination disadvantage and transfer the credit risk of the credit without transferring the loan itself.
The advantages of this approach include:
i. The bank-client relationship is preserved
ii. Alternative strategies, such as sale in the secondary markets or participation, may have adverse consequences for the bank-client relationship.
iii. The bank enjoys the fee-based income associated with the higher level of commitment.
iv. The hedging bank has significantly diversified its risk, only experiencing a default if both the oil company and counterparty bank fail jointly and concurrently to perform. This joint probability of default is likely to be quite low.
v. The return on capital of the hedged position can be significantly higher.
Example 3:
Revenue neutral diversification CDS; Adding loan assets to a portfolio can reduce portfolio variance provided the assets are less positively correlated with the assets in the existing portfolio.
Bank may increase its degree of diversification by adding assets in a way that is neutral in terms of revenue and capital. One way to achieve this is to buy credit protection from highly rated (and not highly correlated) bank counterparty on one or more of its original assets. The premium for this credit default swap may be funded by the sale of protection on other credit assets that are less positively related to the original portfolio.
Given a Credit spread for the acquired risk is at least equivalent to assets put under protection and assuming no other transaction costs, the portfolio risk (defined as the standard deviation) is reduced while portfolio revenue remains neutral.
The advantages are:
i. A reduction in credit concentration as the portfolio diversification is achieved, and
ii. No reduction in portfolio return.
Example 4:
Hedging illiquid bonds; one useful aspect of credit derivatives is their ability to mitigate illiquid credit and market risks. Let us assume that such a security is trading at 90% of par, which may fall further during the remaining maturity period. The bank would like to create a price floor at 90% and give up the opportunity of participating in any appreciation to par.
Solution:
Pay the total return on the security to a credit derivatives dealer, creating a 90% price floor on the investment. By paying the total return for the period leading up to the maturity date, the bank is immunized against any further fall in price below the level of 90%.
5. Hedging Pitfalls in Practice:
Transaction Origination:
Successful credit derivatives dealers endeavor to:
i. Establish client/product suitability
ii. Identify and fully appreciate end-user motivations and portfolio
iii. Provide end users with useful feedback and help manage expectations about the timing of transactions
iv. Understand that transaction terms are generally indicative and not firm
v. Appreciate that dealers may have limits on their appetite for certain credits
vi. Appreciate the limitations and liquidity restraints of the developing credit derivatives market.
Transactions Structuring:
Occurs once a credit derivatives transaction has been originated.
The major terms and conditions/issues to confirm at this stage include:
i. All settlement methods are agreed and market disruption clauses have been considered.
ii. The hedging strategy employed is the most efficient vehicle in terms of funding, relationship issues and capital treatment.
iii. If the reference asset and the underlying credit risk are one and the same, no residual basis risk remains (or, if it does, is identified and priced accordingly). In addition, a thorough check of the reference asset is required to identify any risk of pre-payment, extension, sinking fund or call features.
iv. The assignability of the unvetted underlying assets is established (otherwise alternative settlement techniques need to be established).
v. The parties have a thorough understanding of any materiality tests requirements, especially in the case of non-investment grade credits.
vi. If a credit-linked note is being issued by a founder, it must confirm that credit events in the credit default swap confirmation are mirrored in the credit-linked note pricing supplement.
vii. Credit events are appropriate for the situation.
Transactions Documentation:
All transaction structuring issues must be resolved prior to documentation.
A successful documentation process includes:
i. Presentation by credit derivatives trading to documentation of a transaction term sheet setting out terms and conditions.
ii. Good communication between all members of the credit hedging team.
iii. An appreciation of transaction objectives and goals.
iv. Problem-solving approach with the credit derivatives trading desk, the end-users and other internal partners.
v. A well thought-out transaction template or use of ISDA-sponsored transaction confirmation.
6. Scope of Credit Derivatives in India:
The market acceptability of all derivatives products is increasing in India. With Indian banks increasing their focus on risk management, it is expected that credit derivatives would gain popularity.
An important feature of credit derivatives is its simplicity. Today, banks can sell loans to transfer credit risk. However, this gives rise to a number of problems, particularly with respect to stamp duty payable. Also, in some cases, the borrower needs to be informed of the sale of loan and this can create problems in relationship with borrowers. Credit derivatives allow banks to transfer credit risk, without these problems.