PowerPoint Presentation
IC301
Derivative Securities
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IC301 – Topic 9
Credit Derivatives
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Applications
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Credit events
Credit Default Swaps
Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity)
Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X
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 has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are typically deliverable)
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CDS Structure (Figure 25.1, page 595)
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Default
Protection
Buyer, A
Default
Protection
Seller, B
90 bps per year
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
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 (more usually) in cash
An auction process usually determines the payoff
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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
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Using a CDS to Hedge a Bond Position
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 is (approximately) a long position in a riskless instrument paying 5% per year
This shows that bond yield spreads (measured relative to LIBOR) should be close to CDS spreads
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Credit Indices
CDX NA IG is a portfolio of 125 investment grade companies in North America
iTraxx Europe is a portfolio of 125 European investment grade names
The portfolios are updated on March 20 and Sept 20 each year
The index can be thought of as the cost per name of buying protection against all 125 names
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Total Return Swap (page 603-604)
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 exposure to assets
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Total Return
Payer
Total Return
Receiver
Total Return on Assets
LIBOR plus 25bps
Asset Backed Securities
Securities 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.
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Collateralized Debt Obligations
(Page 605-607)
A cash CDO is an ABS where the underlying assets are debt obligations
A synthetic CDO involves forming a similar structure with short CDS contracts
In a synthetic CDO most junior tranche bears losses first. After it has been wiped out, the second most junior tranche bears losses, and so on
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