PDF Ebook Credit Derivatives Explained: Market, Products, and Regulations
The credit derivatives market has experienced considerable growth over the past five years. From almost nothing in 1995, total market notional now approaches $1 trillion, according to recent estimates. We believe that the market has now achieved a critical mass that will enable it to continue to grow and mature. This growth has been driven by an increasing realization of the advantages credit derivatives possess over the cash alternative, plus the many new possibilities they present.
The primary purpose of credit derivatives is to enable the efficient transfer and repackaging of credit risk. Our definition of credit risk encompasses all credit related events ranging from a spread widening, through a ratings downgrade, all the way to default. Banks in particular are using credit derivatives to hedge credit risk, reduce risk concentrations on their balance sheets, and free up regulatory capital in the process.
In their simplest form, credit derivatives provide a more efficient way to replicate in a derivative form the credit risks that would otherwise exist in a standard cash instrument. For example, as we shall see later, a standard credit default swap can be replicated using a cash bond and the repo market.
In their more exotic form, credit derivatives enable the credit profile of a particular asset or group of assets to be split up and redistributed into a more concentrated or diluted form that appeals to the various risk appetites of investors. The best example of this is the tranched portfolio default swap. With this instrument, yield seeking investors can leverage their credit risk and return by buying first-loss products. More risk-averse investors can then buy lower-risk, lower-return second-loss products.
With the introduction of unfunded products, credit derivatives have for the first time separated the issue of funding from credit. This has made the credit markets more accessible to those with high funding costs and made it cheaper to leverage credit risk.
Recognized as the most widely used and flexible framework for over-the-counter derivatives, the documentation used in most credit derivative transactions is based on the documents and definitions provided by the International Swaps and Derivatives Association (ISDA). In a later section, we discuss in detail the key features of these definitions. We believe that it is only by being open about any limitations or weaknesses in market practice that we can better prepare our clients to participate in the benefits of the credit derivatives market.
Much of the growth in the credit derivatives market has been aided by the growing use of the LIBOR swap curve as an interest rate benchmark. As it represents the rate at which AA-rated commercial banks can borrow in the capital markets, it reflects the credit quality of the banking sector and the cost at which they can hedge their credit risks. It is, therefore, a pricing benchmark. It is also devoid of the idiosyncratic structural and supply factors that have distorted the shapes of the government bond yield curves in a number of important markets.
Bank capital adequacy requirements play a major role in the credit derivatives market. The fact that the participation of banks accounts for over 50% of the market’s outstanding notional means that an understanding of the regulatory treatment of credit derivatives is vital to understanding the market’s dynamics. The 1988 Basel Accord, which set the basic framework for regulatory capital, predates the advent of the credit derivatives market. Consequently, it does not take into account the new opportunities for shorting credit that have been created and are now widely used by banks for optimising their regulatory capital. As a consequence, individual regulators have only recently begun to formalise their own treatments for credit derivatives, with many yet to report. We review and discuss the various treatments currently in use.
A major review of the bank capital adequacy framework is currently in progress: a consultative document has just been published by the Basel Committee on Banking Supervision. We summarize the proposed treatment and discuss what effect.
Investment restrictions prevent many potential investors from participating in the credit derivatives market. However, a number of repackaging vehicles exist that can be used to create securities that satisfy many of these restrictions and open up the credit derivatives market to a wider range of investors. We will discuss these structures in detail. these changes, if implemented, will have on the credit derivatives market.
In some senses, the terminology of the credit derivatives market can be ambiguous to the uninitiated since buying a credit derivative usually means buying credit protection, which is economically equivalent to shorting the credit risk. Equally, selling the credit derivative usually means selling credit protection, which is economically equivalent to going long the credit risk. One must be careful to state whether it is credit protection or credit risk that is being bought or sold. An alternative terminology is to talk of the protection buyer/seller in terms of being the payer/receiver of premium.
Much of the growth of the credit derivatives market would not be possible without the development of models for the pricing and management of credit risk. Overall, we have noticed an increasing sophistication in the market as market participants have developed a more quantitative approach to analysing credit. This is borne out by the widespread interest in such tools as KMV’s firm value model and the Expected Default Frequency (EDF) numbers it produces. We discuss some of the quantitative aspects in Section 3. A survey of the latest credit modelling techniques is available in the Lehman publication Modelling Credit: Theory and Practice, published in February 2001.
Both have proved successful and have had a significant impact in improving price discovery and liquidity in the single-name default swap market. Before any participant can enter into the credit derivatives market, a solid understanding of the mechanics, risks, and pricing of the various instruments is essential. This is the main focus of this report. We hope that those reading it will gain the necessary comfort to begin to profit from the new opportunities that credit derivatives present.
CONTENTS
1 Introduction
2 The Market
3 Credit Risk Framework
4 Single-Name Credit Derivatives
- 4.1 Floating Rate Notes
4.2 Asset Swaps
4.3 Default Swaps
4.4 Credit Linked Notes
4.5 Repackaging Vehicles
4.6 Principal Protected Structures
4.7 Credit Spread Options
4.8 Bond Options
4.9 Total Return Swaps
5 Multi-Name Credit Derivatives
5.1 Index Swaps
- 5.2 Basket Default Swaps
5.3 Understanding Portfolio Trades
5.4 Portfolio Default Swaps
5.5 Collateralized Debt Obligations
5.6 Arbitrage CDOs
5.7 Cash Flow CLOs
5.8 Synthetic CLOs
6 Legal, Regulatory, and Accounting Issues
- 6.1 Legal Documentation
6.2 Bank Regulatory Capital Treatment
6.3 Accounting for Derivatives
7 Glossary of Terms
8 Appendix
9 Bilbliography
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PDF Ebook Credit Derivatives Explained: Market, Products, and Regulations
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