Credit Derivative Strategies: New Thinking on Managing Risk and Return
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Stern School of Business in May of In credit derivative trading strategies early s the interest rate market began a new wave of financial innovation with the development of the swap market, which provided reduced credit margins for borrowers in different markets while allowing derivative houses to gain profits through their role as intermediaries. At each phase of the swap market's development, new interest rate derivatives to were added to product menus. For example, vanilla interest rate swaps paved the way for cross currency swaps bringing the foreign exchange markets into the field and flat-forward foreign exchange contracts contributed to the emergence of the energy swaps market.
In each of these cases, the market was bundling, unbundling, repackaging and transferring risk between counterparties.
One of the latest crazes to hit the market has been the introduction of credit derivatives, mechanisms that allow institutions to unbundle the credit risk portion of traditional debt instruments from market risk in an effort to improve pricing efficiency. Sections 1 and 2 will provide descriptions of the credit derivatives market and the basic instruments that are trading today.
Section 3 offers a more detailed description of two applications of these derivatives that will fuel much of the growth in trading volume over the next few years, loan portfolio management and merger and acquisition deals. These cases begin with a description of the situation facing the counterparties involved and then demonstrate how a customized credit derivative can be applied. The last two sections provide insight into the more pragmatic side of the business where dealers work around pricing, hedging, documentation and regulatory obstacles to put deals together.
While this paper attempts to provide a comprehensive commentary on the state of the credit derivatives market today, the research is by no means exhaustive and access to information on the latest cutting edge trade in these markets can be difficult to obtain. As credit derivative trading strategies a personal computer purchased two months ago, once one understands everything it can do, the PC is probably obsolete.
In the derivatives markets, once a list of all the trades in the market has been compiled, its participants have come up with five or ten new ones. Credit derivatives are privately negotiated bilateral contracts that allow users to manage their exposure to credit risk.
For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit derivative trading strategies risk to another party while keeping the loan on its books.
This mechanism can be used for any debt instrument or a credit derivative trading strategies of instruments for which an objective default price can be determined. In this process, buyers and sellers of the credit risk can achieve various objectives, including reduction of risk concentrations in their portfolios, and access to a portfolio without actually making the loans.
Credit derivatives offer a flexible way of managing credit risk and provide opportunities to enhance yields by purchasing credit synthetically. Credit derivatives cannot eliminate all credit risk because inherent in the transfer of a loan exposure to Company A, is the introduction of a new exposure to Company B because of the use of a derivative with Company B.
Credit risk is the possibility that a borrower will fail to service or repay a debt on time. The degree of risk is reflected in the borrower's credit rating, which defines the premium over the riskless borrowing rate it pays for funds and ultimately the market price of its debt. Credit risk has two variables: Credit derivatives allow credit derivative trading strategies to isolate, price and trade firm-specific credit risk by unbundling a debt instrument or a basket of instruments into its component parts and transferring each risk to those best suited or most interested in managing it.
There are various traditional mechanisms to reduce credit risk including refusal to make a loan, insurance products, guarantees and letters of credit, but these mechanisms are less effective during periods of economic downturn when risks that normally offset each other simultaneously default and financial institutions suffer substantial loan losses.
Credit derivatives have emerged as a major risk management tool in recent years. Once largely credit derivative trading strategies to banks, the market participants have expanded to include insurance companies, hedge funds, mutual funds, pension funds, corporate treasuries and other investors looking for yield enhancement or credit risk transference.
The market has evolved from the financial institutions' needs to credit derivative trading strategies their illiquid credit concentrations and their use of default puts to hedge their credit exposure.
Existing derivative techniques have been used for emerging market debt and have further been applied to corporate bonds and syndicated bank loans. Total Return Swaps, for example, were developed to sell customized exposures to investors looking for a pick-up in yields on their portfolios.
These structures enable investors to obtain exposure to portfolios which were not available to them previously and provides them with new credit derivative trading strategies opportunities.
Several factors have contributed to the development of the credit derivative market. Investors have shown interest in these products for yield enhancement given the increasingly narrow credit margins on conventional corporate and emerging market sovereign issues. As investors have come to understand these products more fully, trading volumes have increased. Now dealers are more frequently warehousing trades in the same way they warehouse and manage interest rate risk. Over-the-counter brokers have entered the market and the International Swaps and Derivatives Association ISDA is responding to the call for standardized documentation.
Comments from most market participants indicate a consensus expectation of continued growth and increased liquidity in the future. Credit derivatives will make credit risk pricing more efficient, much as Collateralized Mortgage Obligations CMOs did for mortgage pricing, and help segregate credit risk from market risk in bond and loan pricing. Institutions best suited to handle the credit risk component of these debt traderxp free binary options demo accounts will be able to buy only that portion of the risk and warehouse it.
The product menu in the credit derivatives market is changing every day, but there are four major instruments that make up the bulk of the trading volume today: Terminology varies among market participants, sometimes based on geography.
For example, Credit Default Swaps are sometimes called Credit Swaps so it is difficult to maintain a consistent lexicon when discussing this developing market. Traders and marketing staff are careful to provide detailed descriptions of a transaction-specific payoff profile so it is of more value to understand under what circumstances one will receive a payment, or be required to make one, than it is to know a list of product names. Table 1, from the British Bankers' Association, provides estimates of how credit derivative trading volume breaks down by product type.
Of most interest in this chart credit derivative trading strategies their view of the credit derivative trading strategies trend in the market which favors the development of products which allow end users to manage their borrowing spread over the risk-free rate. With credit derivative trading strategies broad menu of products for corporate treasurers to manage their absolute exposure to the level of interest rates swaps, caps, collarsthey will next look for ways to stabilize their company's borrowing spreads.
A Total Return Swap is a derivative instrument that allows an investor to receive the total credit derivative trading strategies return of an asset income plus or minus any change in capital value without actually buying the asset. Exhibit 1 is a diagram of TRS cash flows. One party pays the total economic return on a notional amount of principal to another party in credit derivative trading strategies for periodic fixed or floating rate payment credit derivative trading strategies some spread.
The underlying reference credit e. LIBOR can be any financial asset, basket of assets or an index. There can be many variations on the basic TRS structure. For instance, one can use a basket of assets instead of a single credit. Maximum and minimum levels for the floating rate leg of the structure can be set via embedded caps on a reference credit.
Maturity of these swaps generally runs from one to three years. Banks use this product as a way of transferring the risk exposure of an asset to another interested party.
Investors seeking exposure to a bank portfolio use TRSs to enhance their yield. This allows the bank to reduce its exposure to the credit risk portion of the portfolio without selling the loans.
The insurance company, on the other hand, obtains exposure to the portfolio without bearing the expense of originating and administering these loans, except via the bank's margin on the swap. The swap enables banks to keep the entire asset on their books, but maintain only the desired amount of credit exposure. Why is this of value to the banks in an era when return on assets is so carefully scrutinized by equity analysts? It seems on the surface that they would look to move as much off their balance sheet as possible.
In many cases, banks want to keep the loans on their books to avoid jeopardizing their relationship with a customer or breaching client confidentiality.
Investors can leverage and diversify their portfolios to achieve higher credit derivative trading strategies by taking on this credit exposure. A TRS enables the investor to make loans synthetically without the credit derivative trading strategies burden of documenting the loan agreement and periodically resetting the interest rate.
TRSs can provide an extremely economic way of using leverage to maximize return on capital. The exposure on an interest rate is not as large as its notional principal amount since only the respective interest payments are made. Only the total return of the portfolio is exchanged with the fixed or floating semiannual payments. Table 2 is an example of the cash flows of a typical TRS.
At termination Scenario 1 Scenario 2 All-in bond price: A Credit Default Swap is another mechanism for distributing the default risk of securities and loans, enabling lenders and investors to improve risk management and better achieve their financial goals. In this case, one party makes periodic basis points payments and another party makes payments for the principal if the "credit default" event occurs.
The pricing of such a derivative depends upon the credit quality of the reference credit, supply and demand for the reference credit, and prevailing credit spreads. The objective might be any of the following: Exhibit 2 is a CDS cash flow.
Banks that want to reduce or eliminate their exposure to a particular loan or basket of loans can buy a CDS without the borrower's knowledge or consent which may be required when the loans are sold outright. Manufacturing companies that depend upon a limited number of customers for revenue can buy a CDS on their customers' payment obligations.
Investors who need to protect themselves against default but cannot or do not want to sell the at-risk security credit derivative trading strategies accounting, tax or regulatory reasons, can buy a Credit derivative trading strategies Default Credit derivative trading strategies.
Investors can pick up additional yield without buying credit derivative trading strategies asset, holding it on their balance sheet and funding it.
Building on the basic swap structure, investors can swap the default risk of one credit with that of another credit. This can help companies diversify their credit derivative trading strategies while avoiding the transaction costs associated with buying and selling many individual securities or loans.
Credit events in such transactions are pre-defined in the agreement, which could include a payment default, bankruptcy or debt rescheduling. Credit derivative trading strategies credit event must be material and objectively measurable, this has been one of the major issues addressed by the International Swaps and Derivatives Association discussed in Section 5.
The reference credit credit derivative trading strategies be almost any loan or security, a basket of loans or securities, regardless of the currency, and the tenure of the swap can match or be shorter than the tenure of the reference credit. Buying or credit derivative trading strategies an option on a borrower's credit spread provides an opportunity to gain exposure on the borrower's future credit risk.
One can lock in the current spread or earn premium for the risk of adverse movement of credit spreads. It also presents a method of buying securities on credit derivative trading strategies forward basis at favorable prices. Credit Spread Options are normally associated with bonds, which are priced and traded at a spread over a benchmark instrument of comparable maturity. The yield spread represents the risk premium the market demands for holding the issuer's bonds relative to holding riskless assets like U.
Options can refer to the borrower's spread over U. For example, credit derivative trading strategies investor might sell an option on the credit spread of a BBB-rated corporate bond with 5-year maturity to a bank in exchange for a premium credit derivative trading strategies front.
The option gives the bank the right to sell the bond to the investor at a certain strike price assume basis points. The strike price here is expressed in terms of credit spread over the 5-year Treasury note. On the option's exercise date, if the actual spread of the corporate bond is less than basis points, the option expires worthless.
If it is higher than basis points, then the investor delivers the underlying bond and the investor pays the price whose yield spread over the benchmark equals basis points.
This structure allows investors to buy the bonds at attractive terms. If the option expires worthless, the total cost of bond is reduced by the amount of the premium. Otherwise the investor pays for the bond at the chosen strike price. There could be different strategic variations of this, such as i using options on credit spreads to take position on the relative performance of two different bonds and ii locking in the current spread by buying calls and selling puts on the spread with the possibility of earning a premium in the transaction.
Again, this derivative structure allows investors to take a position in the underlying assets synthetically rather than buying assets in the cash market.