You are on page 1of 161

JULY 2006

CREDIT DERIVATIVES

Vaidya Nathan
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 1
Credit derivatives in the context of financial markets growth

New applications
expanding financial
instruments use

re As
O V E R VI E W

a s
u c t s pa n ex et cl
r od to s ird t
tra ende asses
p
w ging & th cts dit d
e
N er nd du ion bey getti
m o o al o n
e sec pr ma nd g
D E R I VA T I VE S

o n rke
rati ts
ne
ge
C R E D I T

VAIDYA NATHAN 2
Role of Credit Derivatives
Motivations
Motivations for
for use
use of
of Credit
Credit Derivatives
Derivatives

Hedge,
transfer and/or
Synthetically mitigate credit Decompose
create loan- exposure and separate
bond; credit risks
alternative to embedded in
equity financial
derivatives instruments
O V E R VI E W

Generate Proactively
leverage or manage credit
yield risk on a
enhancement Manage portfolio basis
regulatory
D E R I VA T I VE S

capital ratios
C R E D I T

VAIDYA NATHAN 3
Credit derivatives isolate and transfer credit risk

Broad definition

„ bilateral financial contract which allows specific aspects of credit risk to be


isolated from the other risks of an instrument, and passed from one
counterparty to another

Credit 60 bps
O V E R VI E W

Loan/bond

FX, 6.60 %
Interest yield
D E R I VA T I VE S

Rate

On-balance sheet
C R E D I T

Off-balance sheet
VAIDYA NATHAN 4
Credit derivatives perform a market completion role

Bond = Duration + Convexity + Credit

Convexity Risk
including callability Credit risk
risk sometimes i.e.
negative convexity
O V E R VI E W
D E R I VA T I VE S

Duration Risk
C R E D I T

VAIDYA NATHAN 5
Efficiency gains arising from disaggregating risk

Auctioneer sells a number of


risks, each to the highest bidder

JOB LOT
O V E R VI E W
D E R I VA T I VE S
C R E D I T

VAIDYA NATHAN 6
Spreads of Credit Default Swaps can be compared to bond yields

Bond / Loan Asset Swap Credit Default Swap

Credit Risk
Credit Risk

Funding Risk Credit Risk

Funding Risk
O V E R VI E W

Risk Free Rate


D E R I VA T I VE S
C R E D I T

VAIDYA NATHAN 7
The simplest instrument: single name credit default swaps

Reference Entity
Risk (Notional)

Fee/premium

B A
Protection Buyer Protection Seller
Contingent Payment
upon a credit event
„ Buy CDS „ Sell CDS
O V E R VI E W

„ Buy Protection „ Sell Protection

„ “Short Risk” „ “Long Risk”

„ Pay periodic payments „ Receive periodic payments


D E R I VA T I VE S

„ Receive contingent payment „ Pay contingent payment


C R E D I T

VAIDYA NATHAN 8
Indicative Summary Terms of CDS
General
General Terms
Terms Fixed
Fixed Payments
Payments
„ Effective Date: 23 Nov 2006 „ Fixed Rate Payer Notional: USD 25,000,000

„ Scheduled Termination Date: 23 Nov 2008 „ Fixed Rate Payer Payment Dates: The 23rd
of February, May, August and November,
„ Floating Rate Payer: X (the “Seller”)
commencing on February 23, 2007
„ Fixed Rate Payer: Y (the “Buyer”)
„ Fixed Rate: X% per annum
„ Business Day: London & New York
„ Fixed Rate Day Count Fraction: Actual/360
„ Business Day Convention: Modified Following

„ Reference Entity: ABC


Floating Payment
Floating Payment
O V E R VI E W

„ Reference Obligation(s) - The obligation(s)


„ Floating Rate Payer Notional: USD 25,000,000
identified as follows:
„ Primary Obligor: ABC Corporation „ Conditions to Payment:
„ Maturity: 15 September 2011 1. Credit Event Notice
„ Notifying Party: Buyer or Seller
D E R I VA T I VE S

„ Coupon: 6.5%
2. Notice of Publicly Available Information
„ CUSIP/ISIN: USXXX Applicable
„ Original Issue Amount: USD 1,000,000,000 „ Public Source(s): Standard Public Sources
„ Specified Number: Two
3. Notice of Physical Settlement
C R E D I T

VAIDYA NATHAN 9
Indicative Summary Terms of CDS
Credit
Credit Events
Events Settlement
Settlement Terms
Terms
„ Credit Events: The following Credit Event(s) „ Settlement Method: Physical Settlement
shall apply to this Transaction:
„ Physical Settlement Period: Section 8.5 of the
„ Bankruptcy
ISDA Credit Derivatives Definitions, subject to a
„ Failure to Pay maximum of 30 Business Days
„ Restructuring
„ Portfolio: Exclude Accrued Interest
„ Grace Period Extension: Not Applicable
„ Deliverable Obligation Category: Bond or Loan
„ Payment Requirement: USD 1,000,000 or its
equivalent in the relevant Obligation „ Deliverable Obligation Characteristics:
Currency „ Pari Passu Ranking
„ Specified Currencies: Standard Specified
O V E R VI E W

„ Default Requirement: USD 10,000,000 or its


Currencies
equivalent in the relevant Obligation
„ Assignable Loan
Currency
„ Consent Required Loan
„ Obligations:
„ Transferable
D E R I VA T I VE S

„ Obligation Category: Borrowed Money


„ Not Contingent
„ Obligation Characteristics: None
„ Maximum Maturity: 30 years
„ Not Bearer
„ Restructuring Maturity Limitation Applicable
C R E D I T

VAIDYA NATHAN 10
In reality assumes two names risk

Reference Entity Risk

X bps per annum


Counterparty Bank
Contingent Payment

„ Buyer decreases exposure to Reference Credit(s), but assumes contingent (“two-


O V E R VI E W

name”) exposure to Seller

„ Seller receives a fee in return for making a Contingent Payment if there is a Credit
Event of the Reference Credit which in turn depends on the financial health of the
D E R I VA T I VE S

bank
C R E D I T

VAIDYA NATHAN 11
Replicating a Credit Default Swap

Corporate Asset

$ 100 T + Corporate Spread (SC)


T + Swap Spread (SS)
Collateral
Investor Swap Market

Libor
Repo rate (L – x)
O V E R VI E W

$ 100 * ( 1 – haircut )

Repo Market
D E R I VA T I VE S

Credit Default Swap Spread (approx.) = Corporate Spread (Sc) – Swap Spread (Ss)

Assumption: Haircut is small ( ≈ 0) & repo rate spread is negligible ( ≈ 0)


C R E D I T

VAIDYA NATHAN 12
Funding Cost Arbitrage

Lender AAA Rated Institution


L – 20 bp
L + 40 bp

BBB Asset
L + 25 bp
Lender AA- Rated Institution

L + 40 bp

BBB Asset
O V E R VI E W

25 bp
AA- Rated Institution AAA Rated Institution

Contingent payment in event of default


D E R I VA T I VE S

L + 40 bp

BBB Asset

Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated


C R E D I T

Risk Weight 20% 50% 100% 100% 150% 100%

VAIDYA NATHAN 13
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 14
Degrees of leverage in various Credit Derivative structures

Baskets Portfolio Tranching

Capital protection +
minimum Linear Senior
coupon/interest

Increasing
Yield Capital protection Mezzanine
First-To-Default

Non-capital protected First-To-Default with First Loss (Junior)


Mark-To-Market
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 15
Ab Initio - Credit-linked notes

Tailored notes
„ Structured for investor’s required currency, maturity, and coupon needs

„ CLNs can be rated and / or listed if required

„ Both physical and cash delivery are available to the investor

„ Provide solutions for many investors restricted from entering into OTC transactions

„ Provide investors with yield and minimum ratings requirements through leveraged
high grade structures
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 16
Structure of a Typical CLN

Interest Rate Swap

Protection Sale
Proceeds

Swap Counterparty SPV Collateral

CDS Premium
CLN Proceeds

Investors
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 17
Linear Baskets

Linear basket swaps allow investors to gain exposure to multiple credits in one
trade

„ Risk buyer takes on exposure to each credit equal to the 1/N of the notional of the
basket, where N is the number of credits in the basket (assuming equal weighting)

„ After the first credit event:


„ swap on the defaulted credit terminates,
„ notional of the trade is reduced by the notional of the defaulted credit,
„ the investor bears exposure to the non-defaulted credits

„ Yield on these structures is additive, since each credit is independent of the other
(the same as yield on first-to-default basket with zero correlation)

„ Advantage of less documentation by taking exposure to many credits in one single


B A S K E T

trade
L I N EA R
&
C L N

VAIDYA NATHAN 18
Advantages of Credit Linked Notes

CP Risk
CP Risk &
& No
No Direct
Direct
Credit Line
Credit Line Derivatives
Derivatives
Usage
Usage Contract
Contract

No
Nosystem
system Non-issuers
Non-issuers
requisites
requisites reference
reference

CLN Advantages
Canbe
Can be Customized
Customized
listed
listed Maturity
Maturity

Relative
Relative Tailored
Tailored
B A S K E T

Value
Value Exposure
Exposure
L I N EA R
&
C L N

VAIDYA NATHAN 19
Disadvantages of CLNs

Lack of Cheapest to
Liquidity Deliver
Option

Medium
Funded Form
Term
& Lack of
View
Leverage
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 20
Linear Baskets - an illustration

X bp per annum on notional 100

A B C D E Investor
Investor
Contingent Payment
(Par — Recovery on Credit E)
Protection Buyer Protection Seller

Example: Green Bottle Swap on 5 equally weighted names on a notional of 100


If Credit E defaults, Protection Seller pays Par and receives the Recovery Value on Credit E
The rest of the swap remains, with the notional falling to 80

X bp per annum on notional 80


B A S K E T

A B C D Investor
Investor
Contingent Payment
L I N EA R

(Par — Recovery on defaulted credit) Protection Seller


Protection Buyer
&
C L N

VAIDYA NATHAN 21
Linear Basket - Example

300 bps A
100 bps
B Equal weighted Linear Basket Spread

= (300 + 100 +400 + 150 +200)/5

=230 bps
400 bps
C
B A S K E T

150 bps
D
L I N EA R

200 bps E
&
C L N

VAIDYA NATHAN 22
Benefits of CDX

Use Credit Default Swaps to maximize liquidity -


Liquidity
Liquidity
portfolios are composed of the most liquid credit
default swap names

Cost efficient and timely access to the Credit Markets


Diversification
Diversification via index swaps and credit-linked securities

Daily reports on actual versus theoretical pricing


Transparency
Transparency
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 23
CDS indices: CDX and iTraxx

Two major CDS indices trade actively at tight bid-ask spreads

„ DJ CDX in North America has 125 names

„ DJ iTraxx Europe has 125 names

Weekly fixings on three CDS indices: DJ iTraxx Europe, HiVol index and
Crossover index

Can also trade loss tranches on index

„ Tranches are like synthetic CDO tranches

„ Just as options are way to trade volatility, tranches are way to trade
default correlations
B A S K E T

„ One-factor Gaussian copula is standard for quoting correlations


L I N EA R
&
C L N

VAIDYA NATHAN 24
CDS indices for Asia and Australia
Nonlinearity
Nonlinearity of
of risky
risky duration
duration for
for half
half and
and double
double credit
credit spreads
spreads

„ iTraxx CJ has 50 Japanese names, with sub-indices for capital goods, tech
and HiVol

„ iTraxx Asia has 30 names from outside Japan with sub-indices for Korea,
Greater China and rest of Asia

„ iTraxx Australia has 25 names

„ CDX.EM has 14 emerging market sovereigns, including Korea, Malaysia and


the Philippines
B A S K E T
L I N EA R
&
C L N

VAIDYA NATHAN 25
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 26
First To Default (FTD) Baskets

First-to-default basket swaps allow investors to leverage their exposure to a


basket of credits

„ After the first credit event, the first-to-default swap terminates and the investor no
longer bears exposure to the non-defaulted credits

„ Yield enhancement in these structures basically depends on the correlation of the


names in the basket

„ Risk buyer takes on exposure to each credit equal to the notional of the basket,
thus achieving leverage of the number of names in the basket
P R O D U C T S
B A S K E T

VAIDYA NATHAN 27
First To Default (FTD) Baskets — an illustration

X bp per annum

A B C D E
Contingent Payment
Protection Buyer (Par - Recovery on Credit E) Protection Seller

„ If Credit E defaults, Protection Seller pays Par and receives the Recovery Value on
Credit E

„ The first-to-default swap is terminated and Protection Seller has no further


exposures

„ The greater the correlation, the greater the probability of multiple defaults in the
P R O D U C T S

basket
B A S K E T

VAIDYA NATHAN 28
Mechanics of a First To Default Basket Structure

„ Risk is sourced from the market

„ First to Default Tranche is sold either in bond or swap form

„ Bank retains “Senior” Tranche

Bank
Market Credit Default
Swaps on
5 CDS on 1st to
Individual Default
Credits
OTC
Investors
P R O D U C T S
B A S K E T

VAIDYA NATHAN 29
From individual default probability to basket default probability

Individual
Individual Basket default probability
default
default Correlation = 0
probability
probability 150 bps A FTD Spread = 575 bps
Correlation
Correlation Taking a leveraged exposure to
of
of a basket is equivalent to
assets
assets trading the correlation
between those names
50 bps
B
Intuition:
Intuition: The
The higher
higher the
the correlation,
correlation, the
the lower
lower the
the
spread
spread on
on the
the leveraged
leveraged piece
piece

100% correlation
200 bps
C
„ The basket behaves like 1 single credit
Protection Seller will expect to receive the
widest of individual spreads Correlation = 1.0

FTD Spd = 200 bps


0% correlation 75 bps
D
P R O D U C T S

„ Each name in the basket behaves


independently. Protection Seller should
receive the sum of the individual spreads
100 bps E
B A S K E T

VAIDYA NATHAN 30
High and Low Correlation – the Tom & Jerry way
High
High &
& Low
Low Correlation
Correlation
P R O D U C T S
B A S K E T

VAIDYA NATHAN 31
Risk illustrated

Correlation = 0

A B

D
C E

Correlation = 1

B
E
C
A

0 < Correlation < 1


P R O D U C T S

A
B E
C D
B A S K E T

VAIDYA NATHAN 32
Actual FTD trades – Example 1
Background
Background Trade Summary
Trade Summary

„ Korean client buys FTD loan on six „ Aggregate bid spread: 537 bps
investment grade credits
„ FTD Basket coupon: 6.75%
„ 50% of names chosen were local credits
„ FTD spread over Libor: 335 bps
„ 50% of names were foreign credits
„ FTD spread over Libor as a % of
„ Inclusion of foreign credits helps aggregate spread: 62%
reduce correlation of the basket which
„ FTD spread over Libor as a % of highest
inturn helps increase spread
bid spread: 163%
„ Non callable

Credit 5-year (bids)


Kookmin Bank 62
KEPCO 54
P R O D U C T S

POSCO 53
Hutchison Whampoa 98
Ford 206
Standard Life Assurance 74
B A S K E T

VAIDYA NATHAN 33
Actual FTD trades – Example 2
Background
Background Trade Summary
Trade Summary

„ Client buys FTD note on five high yield „ Aggregate bid spread: 950 bps
credits
„ FTD Basket coupon: 10.60%
„ Names chosen were high rated (BB)
„ FTD spread over Libor: 720 bps
high yield credits
„ FTD spread over Libor as a % of
„ Clustered spreads
aggregate spread: 75%
„ Spreads have low correlation to
„ FTD spread over Libor as a % of highest
maximize spread
bid spread: 335%
„ Non callable

Credit 5-year (bids) Rating


Amerisource Corporation 160 Ba3/BB
P R O D U C T S

Chesapeake Energy Corporation 215 Ba3/BB-


Mandalay Resort Group 210 Ba2/BB+
Flextronics International Ltd 167 Ba2/BB-
Georgia Pacific Corporation 208 Ba2/BB+
B A S K E T

VAIDYA NATHAN 34
Actual FTD trades – Example 3
Background
Background Trade Summary
Trade Summary

„ Client buys FTD protection on five high „ Aggregate offer spread: 795 bps
yield credits
„ FTD Basket premium: 5.0%
„ Reduced costs relative to hedging each
„ FTD spread over Libor as a % of
of the individual credits
aggregate spread: 63%
„ Sheds substantial portion of the risk
„ FTD spread over Libor as a % of highest
„ Credits have high correlation to bid spread: 222%
minimize cost

Credit 5-year (bids)


Delphi Corporation 113
P R O D U C T S

Ford Motor Company 213


General Motors Acceptance Corporation 157
Lear Corporation 87
Visteorn Corporation 225
B A S K E T

VAIDYA NATHAN 35
Default Correlation
Default correlations are key determinants of hedge ratios which determine basket
premiums that dealers are willing to pay. The boundary conditions for the basket
premium can be restated in terms of the default correlation as follows:

„ Basket premiums should decline with an increase in correlation. A basket of


uncorrelated credits trading at similar spreads produces the largest relative
increase in premium compared to the average single-name default swap premium

„ Default correlations impact the likelihood of multiple defaults up to a given time


horizon. In practice, there is a lack of historical data that could be used to extract
default correlations. Instead, market players use the asset correlation to calculate
default correlation

„ Asset correlations can be extracted from the ability-to-pay process of a portfolio of


firms. Such a process is modeled for an individual firm as its market value of assets
minus liabilities. Market inputs are equity and debt data. The asset correlation
derived in this manner is deterministically related to the default correlation, i.e.
one can be transformed into the other
P R O D U C T S

„ The most difficult factor to incorporate in the model for pricing basket products is
the estimation of the underlying correlations. Estimating the correlation between
two default events cannot be achieved by standard statistical methods. Instead
B A S K E T

some proxy for default or credit behaviour must be used


VAIDYA NATHAN 36
How to deal with correlation?

Model the correlation between names as a result of the correlation of each name with
a systemic “market” variable (CAPM)

„ given a market environment, the names default independently

„ the probability of default of any given name depends on the market environment

„ As correlation approaches zero: FTD Basket Premium = Sum of Basket Component’s


CDS Spreads

„ As correlation approaches one: FTD Basket Premium = Highest Individual CDS Spread
in Basket

„ Investors wishing to maximize premium generated by selling FTD Basket protection


should consider selecting a basket that is relatively uncorrelated
P R O D U C T S
B A S K E T

VAIDYA NATHAN 37
Par spreads for FTD with different betas
Par
Par spreads
spreads for
for FTD
FTD with
with different
different betas
betas
550
Par Spreads with Time for various betas

500

450

400

350 Rate of decrease of spreads is high for high correlation

Beta = 10% Beta = 50% Beta = 90% Max Spread


300

250

200

Time ( yrs)
150
P R O D U C T S

1.00 2.00 3.00 4.01 5.01 6.01 7.01 8.01 9.01 10.01 12.01 15.01 20.02 25.02 30.02 40.03

Basket of five names each trading at 100 bps. Rate of decrease of spreads is high for high correlation
B A S K E T

VAIDYA NATHAN 38
Expected loss for FTD with different betas
Expected
Expected loss
loss for
for FTD
FTD with
with different
different betas
betas
100.00%
Expected Loss for FTD with time for various betas
90.00%

80.00%
Beta = 10% Beta = 50% Beta = 90%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

Time (yrs)
0.00%
P R O D U C T S

0.25 1.00 1.50 2.00 3.00 4.01 5.01 6.01 7.01 8.01 9.01 10.01 12.01 15.01 20.02 25.02 30.02 40.03
B A S K E T

VAIDYA NATHAN 39
Dynamic Hedging Of The FTD Basket

„ The hedging behaviour of a dealer provides some intuition behind the actual basket
premium

„ A dealer that buys protection on a basket from an investor would normally hedge
this transaction by selling default protection on each individual name in the basket

„ As the underlying default premiums shift, the deltas will change and the hedges
will need to be rebalanced dynamically

„ The efficiency with which the hedge can be managed is a key factor that
determines the basket premium

„ For small movements in the hedge ratio, the dealer may not be able to sell or buy
protection and may instead buy or sell bonds to hedge, thus taking on basis risk
P R O D U C T S
B A S K E T

VAIDYA NATHAN 40
Dynamic Hedging Of The FTD Basket
Protection Buyer Protection Seller
X bp per annum

A B C D E FTD
FTDInvestor
Investor
Contingent Payment
(Par - Recovery on Credit E)
Notional = N

AANotional
NotionalNNAA==Hedge
HedgeRatio
RatioAAxxNN

BBNotional
NotionalNNBB==Hedge
HedgeRatio
RatioBBxxNN

CCNotional
NotionalNNCC==Hedge
HedgeRatio
RatioCCxxNN
P R O D U C T S

DDNotional
NotionalNNDD==Hedge
HedgeRatio
RatioDDxxNN

EENotional
NotionalNNEE==Hedge
HedgeRatio
RatioEExxNN
B A S K E T

VAIDYA NATHAN 41
Dynamic Hedging of FTD Basket

„ Following a credit event, the dealer will be forced to unwind


the hedges on the other credits (assuming non-zero deltas for
these credits) 150 bps A
„ The cost of unwinding the hedge would depend on the spread
movement for each of the non-defaulted credits. This, in turn,
would depend on the correlation between the defaulted and
50 bps
B
the non-defaulted credits

„ The greater this correlation, the greater the expected spread


widening for a non-defaulted single-name default swap. This
would imply a greater cost of unwinding the hedge. The dealer
200 bps
C
would therefore maintain a lower delta i.e. sell a lower amount
of protection, to minimise losses from the unwind. This would,
in turn, provide a lower premium to pay for the basket
protection
75 bps
D
P R O D U C T S

„ On the other hand, a low correlation would imply a lower


expected spread change in a non-defaulted credit in the event
of default and consequently a lower cost of unwinding that
hedge. The hedger could therefore maintain a higher delta to
100 bps E
B A S K E T

manage the hedge i.e., sell a higher amount of protection. This


provides a higher premium to pay for the basket protection
VAIDYA NATHAN 42
Investment rationale for a FTD Basket Swap

„ Efficient leverage and limited downside : Investors are able to efficiently leverage
credit risk with a defined downside potential by executing a FTD Basket Swap, since
the swap’s notional amount references a basket that is 5x to 10x its size

„ Limited maximum loss: a $10mm FTD Basket Swap that references a basket of ten
names (aggregate credit exposure of $100mm) still limits the investor’s maximum
loss to the first loss in the basket — or $10mm

„ Basket component correlation premium : FTD baskets that are relatively


uncorrelated pay investors a premium that approaches the sum of the basket’s
component default premiums rather the spread of the basket’s riskiest component

„ Efficient usage of regulatory capital: The notional amount of the swap, rather than
the notional amount of the reference basket, would be used in a risk-based capital
requirement calculation for a US bank. This allows banks to take credit risk to a
reference portfolio that is 5x-10x as large as the notional amount of the swap for
P R O D U C T S

which it must set aside capital


B A S K E T

VAIDYA NATHAN 43
Investment rationale for a FTD Basket Swap

„ Investment grade ratings available: Rating agencies have been willing to provide
investment grade ratings to FTD Basket Swaps that meet rating agency requirements
regarding credit risk and diversification

„ Fund managers with limits on scope of assets to invest: This has allowed investors
that are limited to specific ratings-based investment guidelines to earn premiums
well in excess of those typically found in the single-name investment grade bonds or
credit default swaps

„ Executable via swap or funded note/deposit: Investors may elect sell FTD Basket
protection via a swap or funded credit linked note (CLN)

„ The settlement mechanics of a FTD Basket Swap are identical to a single name
credit default swap (physical settlement of defaulted securities)
P R O D U C T S
B A S K E T

VAIDYA NATHAN 44
First 2 To Default (F2TD) Baskets

„ First-2-to-default basket swaps allow investors to leverage their exposure to a


basket of credits to a lesser extent

„ The protection buyer is protected against the first two defaults

„ Total premium for a F2TD basket should be lesser than for a first to default

„ After the first credit event, contract settles partially and notional of the trade is
reduced by half

„ After the second credit event, contract settles fully and the trade terminates
P R O D U C T S
B A S K E T

VAIDYA NATHAN 45
First 2 To Default (F2TD) Baskets

X bp per annum

A B C D E
Contingent Payment
Protection Buyer (Par - Recovery on Credit E) Protection Seller

„ If Credit E defaults, Protection Seller pays Par and receives the Recovery Value on Credit E

X bp per annum

A B C D

Contingent Payment
Protection Buyer (Par - Recovery on Credit D) Protection Seller
P R O D U C T S

„ If Credit D defaults, Protection Seller pays Par and receives the Recovery Value on Credit D
Trade terminates
B A S K E T

VAIDYA NATHAN 46
First-to-default vs First-2-to-default

Basket Spreads
200

180 180
170
160 158
BPS

145
140 140
135
125
120
112
100
92
80
4Y 5Y 8Y

F2TD FTD1 FTD2


P R O D U C T S

FTD1 : Pacific Dunlop, Pasminco, MIM, Mayne Nickless, Qantas


FTD2 : CWOptus, Boral, United Energy, Woodside, Western Mining
F2TD : FTD1 + FTD2
B A S K E T

VAIDYA NATHAN 47
Other Basket default products

„ Second to default : The protection buyer is protected only against the second default,
and pays a premium until the occurrence of this event. The premium will be less than for
a FTD, since two defaults are always less likely than one (assuming that the credits are
not perfectly correlated)

„ Second, third, fourth or fifth to default : The premium for an nth to default decreases
as n increases, since the probability of n defaults becomes more unlikely. The effect of
correlation is to increase the premium, since this increases the probability of multiple
defaults. Relatively speaking, this effect is more dramatic for larger n

„ Sum of first, second, third, fourth and fifth to default : The total premium for these
five contracts is always greater than the sum of the individual default swap premiums

„ Quanto basket default swap : Similar to other quanto products. Assume that the FTD
basket is cash-settled. Upon a credit event, observe the reference obligation (presumably
denominated in USD), then protection buyer receives 1-R x Quanto FX i.e. an FX rate
agreed
P R O D U C T S

„ Actual Quanto Trade: a Taiwanese investor buys protection and pays a running TWD
fee. The basket consists of 5 names with reference obligations denominated in USD.
There is a credit event, recovery on the deliverable is 40. The Taiwanese investor gets
B A S K E T

(100-40) x whatever FX rate that was agreed at the beginning of the trade. For trades in
general, the fee and the payout don't have to be the same currency
VAIDYA NATHAN 48
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 49
A synthetic tranche is a specific allocation of risk of a synthetic CDO

A synthetic CDO pools the risk of various synthetic assets — corporates, sovereigns,
financials — in the form of a portfolio of CDS

Credit risk is re-allocated from individual credits to tranches

„ Equity owner is in the first loss position

„ Subordinated tranches (including Equity) are leveraged exposures

„ Senior tranches (AAA, AAAA) are de-leveraged exposures

Each tranche exhibits different risk characteristics which reflect its expected share of
portfolio losses as well as its sensitivity to changes in the expected distribution of
losses within the portfolio

An active risk management strategy allows banks to create and offer tranche
protection or exposure on a standalone basis
C D O
S Y N TH E T I C

VAIDYA NATHAN 50
9
Each tranche is defined in terms of pay-off
Example
Example of
of a
a mezzanine
mezzanine tranche
tranche

Tranche
loss
CDS Buyer of CDS Seller of
Protection Protection
Fee

Tranche
loss

Tranche size

Portfolio loss
Tranche size
C D O
S Y N TH E T I C

VAIDYA NATHAN 10
51
Sum of risks (losses) is equal to portfolio risk (loss)

Tranche
loss
Senior
Portfolio loss
Eq. size Mezz. size

Tranche
loss
Mezz. size Mezzanine
Portfolio loss
Mezz. size

Tranche
loss
Eq. size Equity
Portfolio loss
Eq. size
C D O
S Y N TH E T I C

VAIDYA NATHAN 52
11
Risk of a tranche is defined by its position in the capital structure

Portfolio Tranched structure

Individual Third-loss piece De-leveraged


credit default (Senior piece)
swaps

Second-loss piece
Medium risk
(Mezzanine)

First-loss piece Highly leveraged


(Equity)
C D O
S Y N TH E T I C

VAIDYA NATHAN 53
12
Synthetic first loss tranche is created by sourcing delta amount of CDS

„ As in a CDO, risk is sourced from the CDS market; however, the amount of risk
sourced reflects only the risk of the first loss tranche

„ By synthetically reproducing its specific risk profile, any tranche can be created
without the need to place the remainder of the capital structure

Risk This risk is managed through active


rebalancing of the 1st Loss delta
Market Bank
Spread

Risk on 1st Loss Risk on 1st Loss


Tranche Tranche

Delta amount
of CDS on SPV Investor
individual
Spread Spread
credits

Delta is specific to the risk of the


1st Loss Tranche Collateral
C D O
S Y N TH E T I C

VAIDYA NATHAN 54
13
Pricing framework for a synthetic tranche is based on expected loss

„ At the portfolio level, spread compensates for expected loss:

Portfolio Expected Loss = PV (Portfolio Credit Spread)

Risk Compensation for Risk

„ Tranching reallocates losses within the portfolio

„ The spread on an individual tranche must compensate for the tranche


expected loss

Tranche Expected Loss = PV (Tranche Credit Spread)


C D O
S Y N TH E T I C

VAIDYA NATHAN 55
15
To compute expected loss, obtain portfolio loss distribution

Ingredients for the calculation of the loss distribution:


„ Recovery rate for each name — use CDS market estimates

„ Probability of default for each individual name — derived from the credit spread
and recovery rate estimate:

„ PD = S/(1-Recovery Rate)

„ Default correlation between names — derived from historical asset correlations


C D O
S Y N TH E T I C

VAIDYA NATHAN 56
16
Estimating loss distribution requires tranching, spreads & recoveries
A
A simplified
simplified example
example of
of a
a portfolio
portfolio containing
containing only
only one
one name
name

Tranched structure
Portfolio:

Spread (bps) Notional


150 100 60%— Senior

Maturity = 1 year 30%— Mezz

Recovery Rate Assumption = 50% 10%— Eq


C D O
S Y N TH E T I C

VAIDYA NATHAN 57
17
Probability-weighting loss scenarios gives expected loss of tranches
Portfolio
Portfolio loss
loss distribution
distribution

Eq Mezz Senior

0% 50% 100%

Tranche pricing
Tranche pricing
Not ional Port folio loss Mezz Sr
Scenarios Probabilit y default e d Port folio loss (%) Equit y loss loss loss
1 97. 00% 0 0 0% 0% 0% 0%
2 3. 00% 100 50 50% 10% 30% 10%

Whole port folio Equit y Mezz Senior


Expe ct ed loss (% of Not ) 1. 5% 0. 3% 0. 9% 0. 3%
Tranche Not ional 100% 10% 30% 60%
Tranche Spread (bps) 150 300 300 50
C D O
S Y N TH E T I C

VAIDYA NATHAN 58
18
To model loss distribution, we take into account default correlation

Credit Spreads Recovery Rates

Asset Market Implied


Correlations Default Probabilities

Default Correlations

Model

Loss distribution
C D O
S Y N TH E T I C

VAIDYA NATHAN 59
19
Address default correlation in estimating the loss distribution?

„ We model the correlation between names as a result of the correlation of each


name with a systemic market variable (similar to CAPM)
„ Given a market environment, the names default independently

„ However, the probability of default of any given name depends on the market
environment

„ Integrating across all possible market environments yields a loss distribution which
then incorporates the correlation between names
C D O
S Y N TH E T I C

VAIDYA NATHAN 60
20
Probability of default depends on the market environment
1-year default
1-year default probability
probability Specific
Specific market
market scenarios
scenarios
Market Bad Neutral Good
environment

Probability
1/3 1/3 1/3
of market
1 year def. Prob 1 year def. prob 1 year def prob
for “Bad” for “Neutral” for “Good”
(Average over markets)
Name 1 1.0% Name 1 1.90% 1.00% 0.10%
Name 2 2.0% Name 2 3.80% 2.00% 0.20%
Name 3 0.5% Name 3 0.50% 0.50% 0.50%

Name 3 is uncorrelated with the market


C D O
S Y N TH E T I C

VAIDYA NATHAN 61
21
Final loss distribution is calculated by averaging over all scenarios
Probability
Probability of
of loss
loss

Bad
market times 1/3

Loss

Neutral
market times 1/3

Good times 1/3


market Loss
C D O
S Y N TH E T I C

VAIDYA NATHAN 62
22
Loss distribution changes with spreads, recoveries, and correlation
Probability
Probability of
of loss
loss

Senior

when correlation increases

when correlation decreases

when spread decreases when spread increases Loss

Average loss
C D O
S Y N TH E T I C

VAIDYA NATHAN 63
23
Portfolio loss distributions for two portfolios
Tranche
Tranche loss
loss different
different for
for same
same tranche
tranche size
size for
for two
two different
different portfolios
portfolios
C D O
S Y N TH E T I C

VAIDYA NATHAN 64
23
As loss distribution changes, delta of any specific tranche changes

„ In a fully-sold synthetic CDO, the risk of changes in the loss distribution is passed
completely to investors
„ The distribution of losses within the portfolio will fluctuate, but the portfolio
hedge is static

„ In a synthetic tranche, bank’s hedge must offset the risk position of the specific
tranche
„ Initial delta reflects the relative proportion of the portfolio loss distribution
which falls within the tranche

„ Therefore, as the tranche expected loss changes, the delta hedge for that tranche
must also be rebalanced
C D O
S Y N TH E T I C

VAIDYA NATHAN 65
24
Risk management for synthetic tranches is rapidly evolving

„ New technology allows for the creation of synthetic tranches with a range
of attractive characteristics beyond the original static

„ Tranche exposure can be offered in local currency whereas risk is sourced


in a foreign currency

„ Term of tranche credit exposure can differ from the term of the note or
swap

„ Credit exposure of coupons can differ from the exposure of the principal

„ Investor or asset manager can be offered limited portfolio management


flexibility
C D O
S Y N TH E T I C

VAIDYA NATHAN 66
26
Credit derivatives offer some unique characteristics

Credit derivatives:

„ unbundle credit risk from other aspects of ownership (tax,


accounting, liquidity, relationship)

„ are similar in substance to many traditional credit instruments

„ are not triggered by underlying price movements but only by default

„ provide the only efficient short positioning vehicle

„ frequently require explicit consideration of correlation risk

„ are available on- or off-balance sheet and can provide leverage


efficiently
C D O
S Y N TH E T I C

VAIDYA NATHAN 67
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 68
Options on Credit Default Swaps

„ Options on credit default swaps can be structured into trades that work for various
parties with different objectives
„ Fund managers can sell options to earn premium while waiting for spreads to
widen to their target investment levels
„ Hedge funds can sell volatility through options to earn premium
„ Investors can buy callable CLNs/CDS to earn higher returns than on plain-vanilla
CLNs/CDS
„ Investors can buy principal protected notes that are linked to spread tightening
or spread widening options or their combinations
„ Investors can combine CDS options with interest rate or equity products to earn
OP TI ON S

higher returns or reduce their risk profile on their investment


DE R I VAT I VE
CR E D IT

VAIDYA NATHAN 69
Options terminology

„ A call on a credit default swap is the right to buy risk/sell protection (receiver
option)

„ A put on a credit default swap is the right to sell risk/buy protection (payer option)

„ A straddle is a combination of a put and a call at the same strike

„ ATM denotes an option struck at-the-money

„ OTM denotes an option struck out-of-the-money


OP TI ON S
DE R I VAT I VE
CR E D IT

VAIDYA NATHAN 70
Options payout diagrams
Bullish Strategy Bullish Strategy

Decreasing Price Increasing Price Decreasing Price Increasing Price


Increasing Spreads Decreasing Spreads Increasing Spreads Decreasing Spreads

80 bps 50 bps 20 bps 80 bps 50 bps 20 bps


Long call
Short put
(unlimited upside when spreads tighten (unlimited downside when spreads widen,
downside limited to premium paid) upside limited to premium earned)

Short call
Bearish Strategy Bearish Strategy
OP TI ON S

(unlimited downside when


Long put
spreads tighten, upside limited to
(unlimited upside when spreads widen
premium earned)
downside limited to premium paid)
DE R I VAT I VE

Decreasing Price Increasing Price Decreasing Price Increasing Price


Increasing Spreads Decreasing Spreads Increasing Spreads Decreasing Spreads

80 bps 50 bps 20 bps 80 bps 50 bps 20 bps


CR E D IT

VAIDYA NATHAN 71
Options on single name credit default swaps

„ Underlying: 5yr CDS on a single Reference Entity

„ Maturity: 3 months

„ Premium: prices are quoted in cents, premium is paid T+3 business days

„ Strike: At-the-money-spot spread of the 5yr CDS derived from the current trading
level at the time of the trade

„ Exercise: European (only at the maturity of the option)

„ Settlement:
„ Physical: into the 5yr CDS upon exercise at the pre set strike
OP TI ON S

„ Cash: option is unwound upon exercise and cash paid out to client

„ Knock out:
DE R I VAT I VE

„ Both calls and puts knock out in case of a Credit Event on the Reference Entity
CR E D IT

VAIDYA NATHAN 72
Options on TRAC-X Europe

„ TRAC-X Europe options are a liquid, standard product to trade credit volatility on a
macro basis

„ Underlying: TRAC-X Europe 99 Swaps with 20 September 2011 maturity

„ Maturity: 3 months or 6 months

„ Premium: prices are quoted in cents, premium is paid T+3 business days

„ Strike: Preset strikes of 30, 35, 40, 45, 50 and 55, chosen to reflect ATM and OTM
forward levels in increments of 5 bps

„ Exercise: European (only at the maturity of the option)


OP TI ON S

„ Settlement: Physical, into TRAC-X Europe 99 Swaps upon exercise at the pre set
strike
DE R I VAT I VE

„ Knock out: No knock out in case of a Credit Event in TRAC-X Europe 99 Swaps
CR E D IT

VAIDYA NATHAN 73
CR E D IT DE R I VAT I VE OP TI ON S
TRAC-X

VAIDYA NATHAN
74
Trade Idea 1: Long credit trade to earn premium
„ A fund manager who finds France Telecom too tight compared to his target investment levels
could sell an OTM put on France Telecom to earn premium

Manager receives 15 cents


15 ¢
to sell OTM put
Put ATM:
strike: 66 bps
Decreasing Price Increasing Price
Increasing Spread 76 bps Decreasing Spread
BE:
80 bps
OP TI ON S

„ Breakeven analysis:
DE R I VAT I VE

„ Investor receives 15 cents to sell a 3-month European put on France Telecom struck at 76 bps
„ If France Telecom widens by more than 4 bps (= 15 bps / 4.3 duration) from the strike in 3
months, the investor will lose money on the option (I.e., if France Telecom widens beyond 80
bps, the investor will lose more on the option than the option premium earned)
— However, the manager will be put into France Telecom risk at a strike corresponding to
CR E D IT

his target investment level

VAIDYA NATHAN 75
Trade Idea 2A: Short credit trade
„ An investor who believes the market will widen in the short to medium term could buy an ATM
put on TRAC-X Europe to benefit from spreads widening

Put strike:
ATM: 45 bps Increasing Price
Decreasing Price
Increasing Spread Decreasing Spread
BE:
53 bps
36 ¢ Investor pays 30 cents
to buy ATM put

Breakeven analysis:
OP TI ON S

„ Investor pays 36¢ to buy a 3-month maturity European put on TRAC-X Europe struck at 45 bps

„ If TRAC-X Europe widens by more than 8 bps (= 36¢ / 4.3 duration) from the strike in 3 months, the
investor will make money from exercising his ATM put (i.e., if TRAC-X Europe widens beyond 53
DE R I VAT I VE

bps, the investor will make more on the option than the option premium paid)

„ If TRAC-X Europe widens to 60 bps in 3 months, the investor will make 64.5¢ (= (60-45) bps x 4.3
duration) from exercising his ATM put. The investor’s payout ratio in this case will be 1.79 (= 64.5¢
payout / 36¢ option premium paid)
CR E D IT

„ If TRAC-X Europe widens to 70 bps in 3 months, the investor will make 1.1% (= (70-45) bps x 4.3
duration) from exercising his ATM put. The investor’s payout ratio in this case would be 2.99 (=
1.1% payout / 36¢ option premium paid) VAIDYA NATHAN 76
Trade Idea 2B: Short credit trade with capped upside
„ If the same investor finds the ATM put too expensive and thinks market spreads will widen but
not by too much, he could buy an ATM put and sell an OTM put to subsidise cost of the ATM put

Bear spread payout


Put Put
strike: strike:
Decreasing Price Increasing Price
60 bps ATM: 45
Increasing Spread BE: Decreasing Spread
bps
45 bps
30 ¢ Investor pays 21 cents
to buy bear spread

Breakeven analysis:
OP TI ON S

„ Investor pays 30¢ net to buy a 3-month maturity European put on TRAC-X Europe struck at
45 bps and sell a 3-month European put on TRAC-X Europe struck at 60 bps
„ If TRAC-X Europe widens by more than 7 bps (= 30¢ / 4.3 duration) from 50 bps in 3 months,
DE R I VAT I VE

the investor will make money on the ATM put he bought (i.e., the upside from buying the
option will be higher than the option premium paid)
„ Maximum payout on this trade will be 64.5¢, if TRAC-X Europe goes to 60 bps or wider (=
{60 bps – 45 bps} x 4.3 duration). The investor’s payout ratio in this trade is 2.15 (= 64.5¢ /
30¢ option premium paid)
CR E D IT

„ If investor thinks the market will not widen beyond 60 bps, he should put on the bear
spread (payout ratio of 2.15) instead of buying the ATM put outright (payout ratio of 1.79
when spreads are at 60 bps) VAIDYA NATHAN 77
Trade Idea 3: Short volatility trade
„ A hedge fund does not have a strong credit view but believes that credit market will
experience little volatility in the short to medium term could trade volatility and
earn premium by selling a 3-month ATM straddle on TRAC-X Europe

36 ¢
Investor receives 36 cents
to sell straddle

B/E on put: ATM: B/E on call:


53 bps 45 bps 37 bps
Decreasing Price Increasing Price
Increasing Spread Decreasing Spread
OP TI ON S

„ Breakeven analysis:
„ Hedge fund receives 36 cents to sell a 3-month maturity European straddle on
DE R I VAT I VE

TRAC-X Europe struck at 45 bps


„ If TRAC-X Europe tightens or widens by more than 8 bps (= 36¢ / 4.3 duration)
from the strike in 3 months, the fund will lose money on the option (i.e., the
downside from selling the option will be higher than the option premium earned)
CR E D IT

VAIDYA NATHAN 78
Trade Idea 4: Callable CDS
„ A CDS investor with investment targets that are higher than current market levels could sell 10yr France
Telecom protection callable by bank in 5 years that pays more than the 10yr plain-vanilla CDS

Callable CDS
Premium for 10yr FRTEL CDS callable in 5yrs

If 5yr FRTEL CDS < 95 bps in 5yrs


Bank Bank calls the CDS from the investor Investor

If 5yr FRTEL CDS > 95 bps in 5yrs

Investor holds the CDS contract for 10yrs


OP TI ON S

„ Breakeven analysis:
„ 5yr France Telecom CDS: 66 bps, 10yr France Telecom CDS: 89 bps
DE R I VAT I VE

„ 10yr France Telecom CDS callable in 5 years pays 95 bps (WHAT IS THE CATCH HERE?)
„ If Bank calls the CDS in 5 years, investor will have earned 29 bps (44%) more running than the
5yr CDS, and FRTEL 5yr CDS would have to tighten by more than 29 bps for investor to lose
the 29 bps earned in the first 5 years to enter into a new France Telecom CDS
CR E D IT

„ If Bank does not call the CDS, investor will have earned 6 bps (7%) more running than selling
plain-vanilla 10yr protection
VAIDYA NATHAN 79
Binary (Digital) Credit Swaps

Z bps per annum

Protection Buyer Protection Seller

Contingent Payment
(Par)

Clients looking for leverage opportunities on a single name can sell protection in a binary swap

„ In a plain-vanilla credit swap, the protection seller would receive the recovery value of the
OP TI ON S

Reference Credit in a credit event

„ In a binary swap, the protection seller receives no recovery value in a credit event
DE R I VAT I VE

„ Client receives a higher spread to compensate for zero recovery in a credit event
CR E D IT

VAIDYA NATHAN 80
Digital (Binary) Default Swaps

„ Digital default swaps will demand a higher premium than a standard default swap

„ Its price will be sensitive to the recovery rate that has been assumed in the
calibration procedure

„ The higher the recovery rate in the calibration, the higher the calibrated hazard
rates will be

„ Since a digital default swap depends only on the hazard rates and not on the
recovery rate, it has a price that effectively increases with the assumed recovery
OP TI ON S
DE R I VAT I VE
CR E D IT

VAIDYA NATHAN 81
Digital Default Swaps

„ Based on run
above the quote
on ABY offers a
recovery bid-
offer of 35-45
with the
underlying ABY
5yr CDS spread at
297bp

„ An investor who
OP TI ON S

believes the
recovery rate on
ABY will be below
35 in the future
DE R I VAT I VE

should sell ABY


recovery at 35
CR E D IT

VAIDYA NATHAN 82
Digital Default Swaps

Executing this position will result in two trades:

„ Investor will be short protection on a DDS (Digital Default Swap) with a recovery
rate fixed at 35, a spread of 297bps, 5yr maturity

„ Investor will be long protection on a standard CDS, spread of 297bps, same maturity
date

„ The net of the two positions has zero carry

Profiting in Default:

„ If ABY defaults and bonds are trading at 20 (i.e. actual recovery is 20) investor
OP TI ON S

earns 15 points on the combined position:

„ On short protection position (DDS) investor loses 65 (100 – fixed recovery rate of 35)
DE R I VAT I VE

„ On the long protection position (regular CDS) investor earns 80 (100 less cost to buy
bond in market at 20)
CR E D IT

VAIDYA NATHAN 83
Calculate MTM on DDS

Calculate the MTM after one year assuming DDS is now trading at 20 instead of 35

Original positions:

„ Short fixed recover position at 35 (Loss on default is 100 – 35 = 65)

„ Long regular CDS position (Gain on default is 100 – R)

Unwind Positions:

„ Long fixed recovery position at 20 (Gain on default is 100 – 20 = 80)

„ Short regular CDS position (Loss on default is 100 – R)


OP TI ON S

„ Notional: USD 10 million, ignore discount rates

Survival
DE R I VAT I VE

Year Probability
2 0.95
3 0.90
CR E D IT

4 0.85
5 0.80 VAIDYA NATHAN 84
Cancelable Credit Swaps

Y bp per annum

Protection Buyer Protection Seller

Contingent Payment
(Par — Recovery)

Right to cancel
OP TI ON S

„ Seller receives a fee in return for making a Contingent Payment if there is a Credit Event of the
Reference Credit

„ Buyer decreases exposure to Reference Credit(s), but assumes contingent (“two-name”)


DE R I VAT I VE

exposure to Seller

„ Buyer has the right to cancel the trade (European or American option)
CR E D IT

VAIDYA NATHAN 85
Yield Pickup on structured CDS

Vanilla Mitsubishi Corp. CDS

„ 3yrs @ 14bps, 5yrs @ 18bps, 10yrs @ 30bps

Cancelable Mitsubishi Corp. CDS

„ 3yrs @ 15.5bps, 5yrs @ 20.5, 10yrs @ 33.5

Binary Mitsubishi Corp. CDS

„ 3yrs @ 18.6bps, 5yrs @ 24bps, 10yrs @ 40bps


OP TI ON S
DE R I VAT I VE
CR E D IT

VAIDYA NATHAN 86
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

VAIDYA NATHAN 87
Credit Spreads

Credit
Spreads

Credit Spreads
=
Default Probability
x (1-Recovery Rate)
Default Recovery
Probability Rate
VAL U A T I O N
C D S

VAIDYA NATHAN 88
Credit Default Swaps transfer default risk

X bp per annum
Protection Protection
Buyer Seller
Contingent Payment
(Par — Recovery)

„ Via a Credit Default Swap, the Protection Buyer transfers risk that the
Reference Entity will default

„ Protection Seller receives a fee, similar to an insurance premium, and


assumes the risk that the Reference Entity will default

„ Upon a default or Credit Event, protection seller makes a contingent


VAL U A T I O N

payment to the protection Buyer calculated according to the actual losses


(e.g. if Reference Entity recovers at 60%, protection seller pays 40%)
C D S

VAIDYA NATHAN 89
Caselet - EuroAutos

1.6% p.a., Q, Act/360


Broker/Dealer XYZ Bank
No Default Protection Seller Protection Buyer
Zero

Quarterly Payments Stop


Notional
Broker/Dealer XYZ Bank
Default Protection Seller Protection Buyer

Senior Unsecured Obligations with


notional amount of $10mn
VAL U A T I O N
C D S

VAIDYA NATHAN 90
Measure of default probability is required to price risky cash flow

„ Two sources exist:

„ Historical Analysis
Proprietary
i) „ Company/Sector expertise
Assumptions
„ Fundamental Analysis

ii) Market Data „ Calibrate probability against


market levels

„ Since we will be hedging with market instruments, it is essential that we


derive our default probabilities from the same instruments

„ As hedging instruments, credit default swaps offer superior liquidity,


lowest cost, and maximum flexibility
VAL U A T I O N
C D S

VAIDYA NATHAN 91
3
Specifications of credit markets are similar to interest rate markets
Yield
Market Details
Curve
Spd to
Currency USD 2
Mid
Trade Date 16-May-06 Swap Maturity Actual Mid Spreads Swap Zero

Days to Spot 2 # Maturity Dates Times yield Bid Mid Ask rates rates

Value Date 18-May-06 1 1D 19-May-06 0.003 3.500% 2.00 0.00 2.00 3.50% 3.56%

2 1M 19-Jun-06 0.088 3.700% 2.00 0.00 2.00 3.70% 3.76%

Conventions 3 2M 18-Jul-06 0.167 3.785% 2.00 0.00 2.00 3.79% 3.85%

Swap Basis 360 4 3M 18-Aug-06 0.252 3.870% 2.00 0.00 2.00 3.87% 3.93%

Swap Days B 5 4M 18-Sep-06 0.337 3.909% 2.00 0.00 2.00 3.91% 3.96%

MMkt DCC Act/365 6 5M 18-Oct-06 0.419 3.948% 2.00 0.00 2.00 3.95% 3.99%

Swap DCC Act/365 7 6M 20-Nov-06 0.510 3.987% 2.00 0.00 2.00 3.99% 4.03%

Swap cpns PA 2 8 9M 20-Feb-07 0.762 4.065% 2.00 0.00 2.00 4.07% 4.08%

Swap BDC M 9 1Y 18-May-07 1.000 4.130% 2.00 0.00 2.00 4.13% 4.13%

MMkt Basis 360 10 18M 19-Nov-07 1.507 4.177% 2.00 0.00 2.00 4.18% 4.22%

MMkt freq. 4 11 2Y 19-May-08 2.005 4.207% 2.00 0.00 2.00 4.21% 4.25%
VAL U A T I O N

Mean Reversion 0.00 12 3Y 18-May-09 3.003 4.254% 2.00 0.00 2.00 4.25% 4.30%

Interpolation type 1 13 4Y 18-May-10 4.003 4.284% 2.00 0.00 2.00 4.28% 4.33%

Libor Holidays GBP 14 5y 18-May-11 5.003 4.319% 2.00 0.00 2.00 4.32% 4.37%
C D S

VAIDYA NATHAN 92
3
Same as money market conventions

Market
Conventions

CCY AUD EUR GBP HKD JPY SGD USD USR


Days2Spot 1 1 1 1 1 1 1 1
Float Cnv Act/365F Act/360 Act/365F Act/365F Act/360 Act/365F Act/365 Act/360
Fixed Cnv Act/365F 30/360 Act/365F Act/365F Act/365F Act/365F Act/365 30/360
MM Basis 365 360 365 365 360 365 360 360
MM Freq 2 2 2 4 2 2 4 4
Swap CPA 2 1 2 4 2 2 2 2
Swap Days A B A A A A B B
Swap Basis 365 360 365 365 365 365 360 360

Swap Bad Day


Conv M M M M M M M M
LIBOR Hol AUD EUR GBP HKD JPY SGD GBP USR
VAL U A T I O N
C D S

VAIDYA NATHAN 93
3
Additional aspects
Reference Details Credit
Reference
Currency USD Parameters
Trade Date 16-May-06 Fee Pay Payment Payment Mean Spread Recovery
Days to Spot 3 Interval Accrued Index Day Count Bad Day Reversion Interpolation Rate
Settlement Date 19-May-06 Convention Convention (%)
Q FALSE Q Act/365 M 0.00 1 50.00%

Credit Spreads
Tenors 1D 1M 3M 6M 1Y 2Y 3Y
Dates 22-May-06 19-Jun-06 21-Aug-06 20-Nov-06 21-May-07 19-May-08 19-May-09
Bid-Offer
3.0 3.0 3.0 3.0 3.0 3.0 3.0
Spread
Bid Spread 98.50 98.50 118.50 138.50 148.50

Mid Spread 100.0 100.0 120.0 140.0 150.0

Ask Spread 101.50 101.50 121.50 141.50 151.50


Clean Spreads 2.005% 2.005% 2.005% 2.005% 2.417% 2.836% 3.049%
Duration 0.254 0.496 0.967 1.860 2.689

Credit
Reference
VAL U A T I O N

Volatility
Structure
Tenors 1D 1M 3M 6M 1Y 2Y 3Y
Dates 20-May-06 19-Jun-06 19-Aug-06 19-Nov-06 19-May-07 19-May-08 19-May-09
ATM Volatilities 15.00% 15.00% 15.00% 15.00%
C D S

VAIDYA NATHAN 94
3
Trade Specifications
Trade Summary CDS References

CDS Price (Deterministic) 372,020.31 CDS Fee 120.00 bp

CDS Price (Tree) 360,488.06 Trade Recovery Rate 50.00%

Opt. Premium (Tree) 0.00 Maturity 2Y

Opt. Premium(Deterministic) 0.00 Coupon Interval Q

Hedge Cost 0.00 First Fixing Date 19-May-2006

Total 360,488.06 Next Regular Fixing Date 19-May-2006

Trade Inputs Maturity Date 19-May-2008

Trade Notional 100,000,000.00 Fee Day Count ACT/365

Trade Date 16-May-2006 Accrual Bad Day M

Sttlement Date 19-May-2006 Payment Bad Day M

Forward Start Time(eg. 1M, 1Y) 1y CDS Structure

Call / Put Call Pay Accrued Fee on Default FALSE

CDS (Long / Short) Long Pay at Maturity FALSE

Option (Long / Short) Long CDS Fee payment tlll maturity FALSE

Option References Option Exercise Schedule


VAL U A T I O N

Option Maturity 1Y Exercise Exercise Strike

Exercise Interval Q # Unadjusted Adjusted Date(s)


Exercise Effective
19-May-2006
Date
C D S

Maturity Date 21-May-2007 0 19-May-06 19-May-06 19-May-06


VAIDYA NATHAN 95
3
CDS Cashflow due from Buyer and Seller of Protection

Buyer of protection pays quarterly premium to seller until the earlier of a credit event or maturity

X X X X X

3m 6m 9m 12m 15m 18m ... 60m

At inception: PV of both legs are equal


Credit Event

3m 6m 9m 12m 15m 18m ... 60m

100 - R
VAL U A T I O N

The seller of protection pays par less recovery to the protection buyer if there is a credit event
during the life of the contract
C D S

VAIDYA NATHAN 96
CDS Cashflow due from Buyer and Seller of Protection

N
Risky PVFIXED = ∑ S .DFi .SPi .α i
i =1

S is the per-annum CDS spread

N is the number of coupon periods

DFi is the riskless discount factor from time t0 to ti

SPi is the Survival Probability of the reference entity from time t0 to ti

αi is the accrual factor from ti-1 to ti

R is the recovery rate on the delivered obligation


N
Risky PVFLOATING = ∑ (1 − R ).DFi .(SPi −1 − SPi )
VAL U A T I O N

i =1
C D S

VAIDYA NATHAN 97
Valuation of any risky cash flow is based on concept of risky PV

„ As default risk increases, the PV of a risky cash flow decreases

„ This corresponds to discounting a risky cash flow with a risky discount


factor
„ A risky discount factor is alternatively expressed as the product of a
risk-free discount factor and a survival probability

„ To price a “risky” instrument we therefore need


„ Payment structure
„ Risk free discount curve
„ Default probability curve
VAL U A T I O N
C D S

VAIDYA NATHAN 98
2
Deriving default probability from CDS spreads
A
A 1-year
1-year default
default swap
swap with
with annual
annual coupon
coupon

1 year annual CDS


P ND
( 0 ,1) S

(1 − P( ND
0 ,1 ) )
-(1-R)

Period 1
1 ⎡P ND x S - (1 − P ND ) x (1 - R)⎤
0=
(1 + r ) ⎢⎣ ⎥⎦
risk free
VAL U A T I O N
C D S

VAIDYA NATHAN 99
4
By bootstrapping, a term structure of default prob can be estimated
Default
Default probability
probability tree
tree construction
construction

P( 1ND
,2 )
S

S
ND
P ( 0 ,1)

0 (1 − P( 1ND
,2 ) )
(100-R)

(1 − P( ND
0 ,1 ) ) (100-R)

Period 1 Period 2

Using bootstrapping method we can use P(0ND


,1) solved in Period 1 to deduce P(1ND
,2)
in Period 2
VAL U A T I O N
C D S

V A I D Y A N A T H A N 100
5
Useful Rule of Thumb

„ Market equilibrium should ensure that expected loss is equal to the PV of


any spread paid in compensation for bearing the risk:

Spread Expected
loss

S = P D (1 − R)
„ Rearranging gives a simple expression for default probability in terms of
CDS spread and recovery rate

S
P =D

(1 − R)
VAL U A T I O N

1
1−
p(t,T ) =
(1 + s(t : t,T )n )
1− θ
C D S

V A I D Y A N A T H A N 101
6
Calculation of default prob is complicated by a number of factors

„ Recovery assumptions
„ Recovery amount cannot be known in advance; therefore an assumption
must be made
„ Assumptions about what will be recovered can vary:
— Recover a flat cash amount
— Recover a percentage of risk free PV
— Recover a percentage of outstanding notional plus accrued interest

„ Interpolation
„ Credit default swaps typically pay fee quarterly

„ Fee accrual
„ In a standard CDS, only the accrued spread is usually paid at time of
default
VAL U A T I O N
C D S

V A I D Y A N A T H A N 102
7
Effect of recovery assumption on implied survival probability

Higher Default
Probability
High Recovery
Lower Survival
Assumption
Probability

Higher Survival
Low Recovery Probability
Assumption

Lower Default
Probability
VAL U A T I O N
C D S

V A I D Y A N A T H A N 103
Survival probability with time for different recovery rates
Survival
Survival probability
probability with
with time
time for
for different
different recovery
recovery rates
rates (CDS
(CDS Spread
Spread =
= 100
100 bps)
bps)
100.00%
Survival Probabilities with Time

90.00%

80.00%

70.00%

60.00%

50.00%
R= 90% R= 50% R= 10%
40.00%

30.00%

20.00%

10.00%

Time (in y rs)


0.00%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
VAL U A T I O N

For low recovery rate assumptions, survival probability decreases approximately linearly
over time. For high recovery rate assumptions, this relationship is more ‘convex’
C D S

V A I D Y A N A T H A N 104
Decline in survival probability with higher recovery rates
Survival
Survival probability
probability with
with time
time for
for different
different recovery
recovery rates
rates (CDS
(CDS Spread
Spread =
= 100
100 bps)
bps)
Maturity R= 90% R= 50% R= 10%
0 99.99% 100.00% 100.00%
1 91.12% 98.09% 98.93%
2 83.02% 96.21% 97.87%
3 75.64% 94.37% 96.82%
4.0027 68.92% 92.56% 95.78%
5.0027 62.80% 90.79% 94.75%
6.0027 57.21% 89.05% 93.74%
7.0027 52.13% 87.35% 92.73%
8.0055 47.50% 85.67% 91.73%
9.0055 43.28% 84.04% 90.75%
10.0055 39.43% 82.43% 89.78%
11.0055 35.93% 80.85% 88.82%
12.0082 32.73% 79.30% 87.86%
13.0082 29.82% 77.78% 86.92%
14.0082 27.17% 76.29% 85.99%
15.0082 24.76% 74.83% 85.07%
16.011 22.55% 73.40% 84.15%
17.011 20.55% 72.00% 83.25%
18.011 18.73% 70.62% 82.36%
19.011 17.06% 69.27% 81.48%
20.0137 15.55% 67.94% 80.60%
VAL U A T I O N
C D S

V A I D Y A N A T H A N 105
Caselet: a typical problem of front & middle office folks

Bid Mid Ask


Client entered into the following CDS trade a year back Tenors Spread Spread Spread
„ Reference Entity: AT&T Corporation 1D 98.5 100 101.5
1M 98.5 100 101.5
„ Maturity: 5 years
2M 98.5 100 101.5
„ Notional: USD 10 million
3M 98.5 100 101.5
„ Contract Spread: 150 bps 4M 98.5 100 101.5
„ Current bid/offer for AT&T is as below 5M 98.5 100 101.5
6M 98.5 100 101.5
„ Calculate the MTM on the trade
9M 98.5 100 101.5
1Y 98.5 100 101.5
18M 98.5 100 101.5
2Y 98.5 100 101.5
VAL U A T I O N

3Y 98.5 100 101.5


4Y 98.5 100 101.5
5Y 98.5 100 101.5
C D S

V A I D Y A N A T H A N 106
Survival Probabilities As Weighting Factors

K
MTM = ∑ (Current CDS − ContractCDS).DFi .SPi
i =1

Current CDS is the CDS spread currently prevailing in the market

Contract CDS is the CDS spread at which the trade was entered

K is the number of coupon periods

DFi is the riskless discount factor from time t0 to ti

SPi is the Survival Probability of the reference entity from time t0 to ti


VAL U A T I O N
C D S

V A I D Y A N A T H A N 107
Conceptualising CDS Mark-to-Market

ORIGINAL

X X X X X X X

NO CREDIT EVENT
3m 6m 9m 12m 15m 18m ... 60m
X-Y X-Y X-Y

=
15m 18m ... 60m

OFFSET
3m 6m 9m 12m 15m 18m ... 60m
VAL U A T I O N

Y Y Y
C D S

V A I D Y A N A T H A N 108
But the Cash Flows are risky …

ORIGINAL

X X X X X

Nominal Value

CREDIT EVENT
3m 6m 9m 12m 15m 18m ... 60m
Defaulted Obligation X-Y X-Y X-Y

Credit Event
=
15m 18m ... 60m

OFFSET Defaulted Obligation Annuity Cancelled

3m 6m 9m 12m 15m 18m ... 60m Default Payments Net off


VAL U A T I O N

Nominal Value
Y
C D S

V A I D Y A N A T H A N 109
Forward default probability for different recovery rates
Forward
Forward default
default probability
probability with
with time
time for
for different
different recovery
recovery rates
rates (CDS
(CDS Spread
Spread =
= 100
100 bps)
bps)

Forward Default Probabilities with Time

10.00%

9.00%

8.00%

7.00%

6.00%

5.00%
R= 90% R= 50% R= 10%
4.00%

3.00%

2.00%

1.00%

0.00% Time (in yrs)


1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
VAL U A T I O N

For low recovery rate assumptions, forward default probability decreases approximately
linearly over time. For high recovery rate assumptions, it decreases exponentially
C D S

V A I D Y A N A T H A N 110
Increased forward default probability with higher R
Forward
Forward default
default probability
probability with
with time
time for
for different
different recovery
recovery rates
rates (CDS
(CDS Spread
Spread =
= 100
100 bps)
bps)
Maturity R= 90% R= 50% R= 10%
1 8.87% 1.91% 1.07%
2 8.10% 1.88% 1.06%
3 7.38% 1.84% 1.05%
4.0027 6.72% 1.81% 1.04%
5.0027 6.12% 1.77% 1.03%
6.0027 5.58% 1.74% 1.02%
7.0027 5.08% 1.70% 1.01%
8.0055 4.63% 1.67% 0.99%
9.0055 4.22% 1.64% 0.98%
10.0055 3.85% 1.61% 0.97%
11.0055 3.50% 1.58% 0.96%
12.0082 3.20% 1.55% 0.95%
13.0082 2.91% 1.52% 0.94%
14.0082 2.65% 1.49% 0.93%
15.0082 2.41% 1.46% 0.92%
16.011 2.20% 1.43% 0.91%
17.011 2.00% 1.40% 0.90%
18.011 1.82% 1.38% 0.89%
VAL U A T I O N

19.011 1.66% 1.35% 0.88%


20.0137 1.52% 1.33% 0.88%
C D S

V A I D Y A N A T H A N 111
Issuer-Weighted Recovery Rate Descriptive Statistics

Mean (1982 -
Priority in Capital Structure 2003) Mean (2004)
Senior Secured 57.4% 80.8%
Senior Unsecured 44.9% 50.1%
Senior Subordinated 39.1% 44.4%
Subordinated 32.0% NA
Junior Subordinated 28.9% NA
All Bonds 42.2% 54.3%
VAL U A T I O N
C D S

V A I D Y A N A T H A N 112
Effect of recovery assumption on risky duration

Higher Default
Probability
High Recovery Lower Survival
Assumption Probability

Lower “Risky
Duration”

Higher “Risky
Duration”

Higher Survival
Low Recovery Probability
Assumption
VAL U A T I O N

Lower Default
Probability
C D S

V A I D Y A N A T H A N 113
Risky Duration for different credit spreads
Risky
Risky Duration
Duration for
for constant
constant term
term structure
structure of
of credit
credit spreads
spreads
8
Risky duration for different credit spreads

Spread 50 bps flat Spread 100 bps flat Spread 200 bps flat

2
VAL U A T I O N

Maturity

1D 1M 2M 3M 4M 5M 6M 9M 1Y 18M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y
C D S

V A I D Y A N A T H A N 114
Nonlinearity of risky duration
Nonlinearity
Nonlinearity of
of risky
risky duration
duration for
for half
half and
and double
double credit
credit spreads
spreads
Spread 50 Spread 100 Spread 200
Maturity Mat times bps flat Duration bps flat Duration bps flat Duration
1D 0.003 50.0 0.0027 100.0 0.0027 200.0 0.0027
1M 0.077 50.0 0.0764 100.0 0.0764 200.0 0.0763
2M 0.170 50.0 0.1684 100.0 0.1681 200.0 0.1675
3M 0.244 50.0 0.2410 100.0 0.2404 200.0 0.2392
4M 0.329 50.0 0.3245 100.0 0.3237 200.0 0.3220
5M 0.416 50.0 0.4100 100.0 0.4087 200.0 0.4061
6M 0.496 50.0 0.4869 100.0 0.4851 200.0 0.4816
9M 0.748 50.0 0.7297 100.0 0.7261 200.0 0.7190
1Y 1.000 50.0 0.9693 100.0 0.9634 200.0 0.9517
18M 1.496 50.0 1.4316 100.0 1.4194 200.0 1.3955
2Y 2.000 50.0 1.8893 100.0 1.8687 200.0 1.8285
3Y 3.008 50.0 2.7721 100.0 2.7330 200.0 2.6604
4Y 4.005 50.0 3.5954 100.0 3.5253 200.0 3.3929
5Y 5.003 50.0 4.3756 100.0 4.2687 200.0 4.0663
6Y 6.003 50.0 5.1179 100.0 4.9708 200.0 4.6947
7Y 7.005 50.0 5.8222 100.0 5.6303 200.0 5.2733
8Y 8.014 50.0 6.4956 100.0 6.2596 200.0 5.8261
VAL U A T I O N

9Y 9.011 50.0 7.1196 100.0 6.8308 200.0 6.3039


10Y 10.008 50.0 7.7092 100.0 7.3654 200.0 6.7428
C D S

V A I D Y A N A T H A N 115
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

V A I D Y A N A T H A N 116
Framework

„ Every credit default swap is documented in a contract based on the ISDA format -
called the Confirmation

„ The terms used in the Confirmation are defined in the 2003 Credit Derivatives
Definitions (formerly 1999 Definitions)

„ A high level of standardisation of documentation exists in the market

„ Standardization makes credit default swaps easier to trade, creates transparency


and facilitates market participation
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 117
Key Contract Terms

„ Reference Entity - the entity that credit protection covers

„ Obligations - Borrowed Money, Bonds or Loans are types of obligations that the
protection covers

„ Credit Events - the triggers are Bankruptcy, Repudiation/Moratorium, Failure to


Pay and Restructuring, Obligation Acceleration
„ Bankruptcy – covers insolvency, appointment of administrators/liquidators, creditor
arrangements, etc
„ Failure to Pay – on one or more Obligations after expiration of any applicable grace period
„ Restructuring – agreement between Reference Entity and holders of any Obligation (and
R O ADMAP

such agreement is not provided for under the terms of that Obligation) with respect to
reduction of interest or principal, postponement of payment of interest or principal, change
of currency (other than “Permitted Currency”) and subordination
DE R I VAT I VE S

„ Deliverable Obligations - settle contracts with Bonds or Loans with predefined


characteristics
CR E D IT

V A I D Y A N A T H A N 118
Key Contract Terms - Deliverable Obligations

„ If a Credit Event Deliverable Obligation Deliverable Obligation


occurs, the Buyer of Categories: Characteristics:
protection can
No Payment Yes Not Subordinated
deliver Deliverable Specified Currency -
No Borrowed Money Yes
Obligations to the Standard Specified Currencies
Reference
Seller No Obligation(s) Only No Not Sovereign Lender

No Not Domestic Currency


No Bond
„ Deliverable No Not Domestic Law
No Loan No Listed
Obligations are not Yes Bond or Loan Yes Not Contingent
the same as No Not Domestic Issuance
Yes Assignable Loan
Obligations — they Yes Consent Required Loan
R O ADMAP

are more narrowly No Direct Loan Participation


No Indirect Loan Participation
defined Qualifying Participation Seller
Yes Transferable
DE R I VAT I VE S

30 years Maximum Maturity


No Accelerated or Matured
Yes Not Bearer
CR E D IT

V A I D Y A N A T H A N 119
2003 Definitions - Why Introduce and Key Changes

„ Why Introduce
„ To consolidate market experience - the 2003 Definitions represent a development
of the 1999 Definitions.
„ Too many supplements (now incorporated)
„ Modified Restructuring was not adopted in Europe
„ Time to overhaul and clean up definitions

„ Key Changes
„ Modified Modified Restructuring for Europe
R O ADMAP

„ New Settlement Fallbacks


„ New Guarantee provisions
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 120
CDS Structural Roadmap
REFERENCE ENTITY Underlying credit risk transferred?

CREDIT EVENT Types of "default" covered

OBLIGATIONS Default on which instruments qualify

PROTECTION PERIOD Occurance of Credit Event


R O ADMAP

REFERENCE OBLIGATION Seniority of exposure transferred


DE R I VAT I VE S

DELIVERABLE OBLIGATION Instruments used for settlement

PHYSICAL SETTLEMENT CDS settlement


CR E D IT

V A I D Y A N A T H A N 121
Caselet: Armstrong World Industries
US
US company
company Armstrong
Armstrong World
World Industries
Industries missed
missed payments
payments on
on its
its debt
debt

„ US company Armstrong World Industries missed payments on its debt,


which triggered credit default swaps

„ Its parent company Armstrong Holdings however, did not default

„ Many market participants had treated the parent and principal subsidiary
interchangeably and had hedged positions with offsetting contracts in the
other entity

„ The lesson here is that there may be substantial credit basis risk between
different entities in the same group
R O ADMAP

„ Worse still, certain contracts in the market had referenced simply


Armstrong without clarifying to which specific entity the contract
DE R I VAT I VE S

referred
CR E D IT

V A I D Y A N A T H A N 122
Caselet: National Power
National
National Power
Power PLC
PLC demerged
demerged certain
certain assets
assets and
and subsidiaries
subsidiaries into
into two
two entities
entities

„ In November 2000, National Power PLC of the UK demerged certain assets


and subsidiaries into two entities: Innogy and International Power

„ In consideration for the transfer of assets to Innogy, shareholders were


given holdings in the new entity

„ National Power then changed its name to International Power

„ Innogy also assumed certain debt obligations of National Power

„ This demerger prompted substantial debate as to whether Innogy had


R O ADMAP

become a Successor
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 123
Non Sovereign Decision Tree
Non-Sovereign
Non-Sovereign Successor
Successor Summary
Summary Decision
Decision Tree
Tree

Does New Entity have >75% of It is the Sole Successor for the for the Entire
Obligations? Credit Derivative Transaction
YES

NO

YES YES
Does New Entity have <25% of Does Reference No Change to
R O ADMAP

Obligations? Entity still exist Contract

NO
DE R I VAT I VE S

NO
New Entity Taking
Each Successor Assigned New Largest % of
Credit Derivative Transaction – Relevant Obligations
Includes Reference Entity >25% is Successor
CR E D IT

V A I D Y A N A T H A N 124
Caselet: Xerox Corporation
Xerox
Xerox extended
extended the
the date
date for
for repayment
repayment of
of principal
principal

„ In the summer of 2002, as part of a wider agreement with its banks,


Xerox extended the date for repayment of principal

„ This was in respect of a major syndicated bank facility that was due for
repayment in September

„ However, market participants entered a legal dispute about whether this


was a result of a deterioration in creditworthiness

„ And over what period prior to Restructuring such deterioration could


reasonably have occurred
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 125
Caselet: Argentina
Obligation
Obligation Exchange
Exchange requirements
requirements

„ Obligation Exchange requirements became the subject of legal disputes

„ Argentina was facing a tight liquidity situation

„ It “requested” local investors to exchange $50bn of bonds for new issues


with lower coupons

„ In question was the meaning of “mandatory” in such circumstances


R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 126
Caselet: Railtrack
Bankruptcy
Bankruptcy Credit
Credit Event
Event

„ On 7 October 2000, Railtrack plc was placed by the UK government into


Special Railways Administration

„ This constituted a Bankruptcy Credit Event

„ The announcement date was a Saturday

„ Investors who bought credit default swap protection on the Wednesday,


Thursday or Friday of the previous week would have not been covered for
this Credit Event
R O ADMAP

„ Under the current conventions, however, such risks are considerably


reduced
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 127
Caselet: Railtrack CTD Obligation
“Widows
“Widows and
and orphans”
orphans” clause
clause

„ Following the Railtrack Bankruptcy Credit Event in 2000, the cheapest-to-


deliver obligation was the 3.5% of 2009 exchangeable bond

„ Most of the market took the view that, provided the bond is
exchangeable or convertible at the option of the holder, the bondholder
should be the beneficiary and the exchange or conversion option within
its control

„ One further complication in the Railtrack case was the inclusion of a so


called “widows and orphans” clause in the exchangeable bond which gave
R O ADMAP

the trustee the right to force conversion of the bond on the holder in
certain circumstances where it was viewed as being in the interests of
the investor
DE R I VAT I VE S

„ After a protracted legal dispute, in February 2003, UK courts ruled in


favour of deliverability
CR E D IT

V A I D Y A N A T H A N 128
Caselet: Marconi
Somewhat
Somewhat unusual
unusual guarantee
guarantee structure
structure

„ The Marconi group had a somewhat unusual guarantee structure

„ The holding company Marconi PLC provided lenders and bondholders of


subsidiary Marconi Corporation PLC with a guarantee

„ Although the bond guarantees were stated to be “unconditional” they


contained a provision that they would fall away upon the repayment of
certain other guaranteed obligations

„ In 2002 a Bankruptcy Credit Event occurred in relation to Marconi, and


the approach of market participants was to deliver loans instead of
R O ADMAP

bonds, so as to avoid the risk that the guarantee structure would render
the bonds undeliverable (under 1999 Definitions)

„ The main exception to this, was where the bond in question was stated as
DE R I VAT I VE S

the Reference Obligation since in most circumstances this is deliverable


CR E D IT

V A I D Y A N A T H A N 129
Caselet: Xerox Syndicated Bank Loan extension
Pressure
Pressure on
on Mod-R
Mod-R

„ Mod-R worked pretty well in the US till it came under pressure

„ In summer 2002, Xerox extended maturities of a syndicated bank loan

„ In this case the maturity limitation requirements of Mod-R did not really
insulate Sellers of protection from the “cheapest-to-deliver” risk

„ This was because, although not long dated, Xerox’s yen bonds were
trading about 15-20 points lower than where the dollar bank loans were
quoted
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 130
Modified Modified Restructuring

New features:

„ The Restructured Obligation must be a Multiple Holder Obligation (i.e.


more than three holders)

„ If Buyer triggers the contract

— Deliverable Obligations subject to a maturity cap of 60 months for the


Restructured Bond or Loan, 30 months for others AND must be
R O ADMAP

Conditionally Transferable Obligations (matches LMA standard)

— Buyer may elect to partially settle


DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 131
Modified Modified Restructuring

„ In 2005, a customer buys 5 year protection on EnergyCo

„ June 2006, EnergyCo enters legally binding agreement to restructure


certain of its bonds

„ You can deliver (1) restructured bonds maturing before mid 2011 and
(2) non restructured bonds maturing before 2010

30 month 60 month
Maturity Maturity Maturity
Cap Floor Cap
R O ADMAP
DE R I VAT I VE S

2005 2006 2007 2008 2009 2010 2011 2012


Effective Legally effective STD
date of
Restructuring
CR E D IT

V A I D Y A N A T H A N 132
Modified Modified Restructuring - US and Europe

Feature: MR (US standard) MMR (European Standard)

Maturity Cap: 30 month cap • 30 month cap for non


Floored at STD restructured obligations
• 60 month cap for restructured
obligations
• Floored at STD

Transferability: Must be transferable to Must be transferable to entities


extensive list of entities regularly engaged in loan and
without consent. securities markets with consent
not to be unreasonably withheld
R O ADMAP

Obligations covered: At least three holders and At least three holders and in the
DE R I VAT I VE S

requires a 2/3 majority to case of a Loan, requires a 2/3


implement restructuring. majority to implement
restructuring
CR E D IT

V A I D Y A N A T H A N 133
New Settlement Fallbacks

„ To avoid failed contracts, parties now have an indefinite period of time to settle
the contract

„ Buyer must attempt scheduled settlement but if this fails, fallbacks will apply

„ Buyer may continue to attempt delivery

„ Seller may close out by buying in the Deliverable Obligation or nominating an


alternative for delivery
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 134
New Settlement Fallbacks - Bond Delivery

„ Buyer has 30 calendar days to deliver a Settlement Notice

„ Buyer has 30 Business Days + 5 Business Day fallback to effect delivery of the Bonds

„ If Delivery has not occurred by this date, Seller may buy the Bond in at the lowest
offer. Seller has 4 Business Days to complete the process

„ If Seller fails to complete the process, Buyer may continue to attempt delivery.
Buyer can not deliver whilst the buy-in process is in operation

„ Seller may try to buy the Bond in again, but must wait at least 8 Business Days
before restarting the process
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 135
New Settlement Fallbacks - Bond Delivery

Buy-in may start any time

Buy-in max Buy-in max


4 BD ≥ 8 BD 4 BD
30 days 30 + 5 BD

Event Last day to deliver Last day for


Determination Notice of Physical delivery of Bonds
R O ADMAP

Date Settlement before fallbacks


begin
Buyer may continue to
attempt to deliver between
DE R I VAT I VE S

buy-in attempts by Seller


CR E D IT

V A I D Y A N A T H A N 136
New Settlement Fallbacks - Loan Delivery

„ Buyer has 30 calendar days to deliver a Settlement Notice

„ Buyer has 30 Business Days + 5 Business Day fallback to effect delivery of the Loan

„ If Delivery has not occurred by this date, Buyer may deliver a Transferable Bond
or an Assignable Loan instead provided that Buyer provides certification from a
Managing Director that reasonable efforts were used to get consent
„ If Buyer has not delivered anything for a further 15 Business Days, Seller may
nominate an Assignable Loan or a Transferable Bond and require Buyer to purchase
and deliver
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 137
New Settlement Fallbacks - Loan Delivery

Buyer can deliver any other Assignable


Loan or Transferable Bond

Seller can nominate an available


30 days 30 + 5 BD 15 BD Loan or Bond
R O ADMAP

Event Last day to deliver Last day for delivery


Determination Notice of Physical of loans before
Date Settlement fallbacks begin
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 138
New Guarantee Provisions

„ Users can now select what type of guarantees can trigger the contract and what is
deliverable

„ Guarantee has to be a “Qualifying Guarantee” i.e. a written instrument where


Reference Entity irrevocably agrees to make payment

„ Upstream, downstream, side-stream and third party guarantees may be identified


and treated separately

„ Europe “All Guarantees” will be adopted. In US “Qualifying Affiliate Guarantees”


will be adopted

„ Qualifying Affiliate Guarantee – Reference Entity guarantees debt of an affiliate


R O ADMAP

where it owns more than 50 percent of the voting shares of that affiliate
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 139
New Guarantee Provisions
Europe and Asia –
covers all these
Qualifying Guarantees
Parent
Company
50%
50% Guarantee

Operating Reference
Company Guarantee Entity Guarantee

US - the only Qualifying Third Party


R O ADMAP

Guarantee
Affiliate Guarantee – 50%
downstream with a
holding of at least 50% Subsidiary
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 140
Other Key Changes

„ CHF is now a standard deliverable currency

„ Notice of Intended Physical Settlement becomes Notice of Physical Settlement


(“NPS”)

„ Pari Passu Ranking becomes Not Subordinated

„ Minor amendments to Restructuring definition, Successor definitions

„ Not Contingent definition revised to remove need for a coupon

„ Convertibles language broadened to accommodate wider range of deliverables

„ Public Sources broadened to include Australian Financial Review et al plus the main
R O ADMAP

source of business news in country of Reference Entity

„ Scheduled Termination Date no longer subject to adjustment


DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 141
Other Key Changes

„ Modified Following replaced with Following as standard convention for all trades

„ Valuation provisions restructured so that all Firm Bids are used regardless of
Quotation Size, with zero only deemed for the no bid portion

„ Repudiation/Moratorium redrafted to require a subsequent Failure to Pay (in any


size) before the earlier of (a) 60 days and (b) the next payment date for the
instrument. Buyer must also deliver a notice of a Potential Repudiation/Moratorium
R O ADMAP
DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 142
Outline
Page

Credit Derivatives Overview 1

CLN & Linear Basket 14

Basket Products 26

Synthetic CDO 49

Credit Derivative Options 68

CDS Valuation 87
D E R I V A T I V E S

Credit Derivatives Roadmap 116

Credit Derivatives Update 143


C R E D I T

V A I D Y A N A T H A N 143
Applications for credit derivatives in the global market
Motivations
Motivations for
for using
using Credit
Credit Derivatives
Derivatives

1. Trading/ market making

2. Product structuring

3. Hedging trading
instruments

4. Active portfolio/ asset


management
U PDAT E

5. Management of
individual credit lines
DE R I VAT I VE S

6. Management of
regulatory capital

7. Management of
economic capital
CR E D IT

V A I D Y A N A T H A N 144
Rankings for application of Credit Derivatives

Applications for credit derivatives Rankings 2003 Rankings 2006 (E)

Trading/market making 1 1

Product structuring 2 2

Hedging trading instruments 3 4

Active portfolio/asset management 4 3

Management of individual credit lines 5 5


U PDAT E

Management of regulatory capital 6 7


DE R I VAT I VE S

Management of economic capital 7 6


CR E D IT

V A I D Y A N A T H A N 145
Credit Derivatives positions
Credit
Credit Derivatives
Derivatives positions
positions

1997 180

1998 350

1999 586

2000 893

2001 1189

2002
U PDAT E

1952

2003 3548
DE R I VAT I VE S

2004 5021

2006 (E) 8206


CR E D IT

V A I D Y A N A T H A N 146
Comparative Interest rate derivatives growth
Interest
Interest Rate
Rate Growth
Growth (USD
(USD billion)
billion)

141,991

121,799

101,658

89,955

77,568

67,465
64,125 64,668
60,091
54,072
50,015
42,368
U PDAT E
DE R I VAT I VE S

Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03
CR E D IT

V A I D Y A N A T H A N 147
Breakdown of market participation
Market
Market Composition
Composition

24%
42%

34%
U PDAT E
DE R I VAT I VE S

Intermediary / Market Maker Buyer Seller


CR E D IT

V A I D Y A N A T H A N 148
Institutions using credit derivatives to buy protection
Buyers
Buyers of
of credit
credit protection
protection
3% 3% 1%
2006 (Expected) Other 2003
7% Banks
Pension fundsAgencies 3% Securities houses
2%
Mutual funds 5%
Hedge funds
5%
Corporates
Insurance 16%
51% Insurance Companies
Companies
9% Mutual funds
Pension funds
Banks
Corporates 43% Other Agencies
4% 16%
1% 1% 1%
1999 7%
U PDAT E

6% Banks
Securities houses
3%
Hedge funds Hedge funds
DE R I VAT I VE S

17% Corporates
Insurance Companies

18% Mutual funds


Securities Pension funds
63%
houses Other Agencies
CR E D IT

15%

V A I D Y A N A T H A N 149
Sellers of credit protection
Institutions
Institutions using
using credit
credit derivatives
derivatives to
to sell
sell protection
protection
4% 1%
4%
2006 (Expected) 2003
Other Banks

Pension fundsAgencies Securities houses


1% Hedge funds
Mutual funds 6%
6% 20% 38% Corporates
Insurance Companies
Banks 2% Mutual funds
34% Pension funds
Other Agencies
Insurance 15%
Companies 16%
21% 1999
2% 3% 1%
U PDAT E

Banks
Securities houses
Hedge funds
DE R I VAT I VE S

Corporates 23% Corporates


3% Insurance Companies
47%
Securities Mutual funds
Hedge funds 3%
houses
15% Pension funds
14% 5%
CR E D IT

Other Agencies
16%
V A I D Y A N A T H A N 150
Credit Derivatives by region
Credit
Credit Derivatives
Derivatives by
by region
region in
in 2006
2006 (Expected)
(Expected)

3%

39% 43%
U PDAT E

10% 5%
DE R I VAT I VE S
CR E D IT

London Europe ex-London Asia/Australia US Other


V A I D Y A N A T H A N 151
Credit Derivatives by region in 2003 & 1999
Credit
Credit Derivatives
Derivatives by
by region
region

2003 1999
45%
44%
41%
40%
U PDAT E
DE R I VAT I VE S

9% 8%
6% 5%
1% 1%
CR E D IT

London Europe ex- Asia/Australia US Other London Europe ex- Asia/Australia US Other
London London
V A I D Y A N A T H A N 152
Credit Derivatives booked by region
Credit
Credit Derivatives
Derivatives booked
booked by
by region
region

14%
6%
14%
66%
U PDAT E
DE R I VAT I VE S

London Europe ex-London Asia/Australia US


CR E D IT

V A I D Y A N A T H A N 153
Credit Derivatives Market Size by region

Credit Derivatives Market Size (US$ bn) 2003 2004 2006

Global market size 3,548 5,021 8,206

London market size 1,586 2,230 3,563

Americas market size 1,459 2,000 3,173

Asia/Australia market size 287 446 858


U PDAT E

Other Europe/Rest of World 216 345 612


DE R I VAT I VE S
CR E D IT

V A I D Y A N A T H A N 154
Global Credit Derivatives Product Usage
Global
Global Credit
Credit Derivatives
Derivatives Product
Product Usage
Usage

2% 1% 1%
4%
4% 51%
Single-name credit default swaps
4%
Synthetic CDOs – full capital
Synthetic CDOs – partial capital
6%
Full index trades
Tranched index trades
2%
Credit linked notes
Total return swaps
U PDAT E

9% Basket products
Asset swaps
DE R I VAT I VE S

Credit spread options


Swaptions
10% Equity linked credit products
CR E D IT

6%

V A I D Y A N A T H A N 155
Current Product Usage
Global
Global Credit
Credit Derivatives
Derivatives Product
Product Usage
Usage –– 2006
2006 (Expected)
(Expected)

3%
3% 1%
3%
42%
5%
Single-name credit default swaps
4% Synthetic CDOs – full capital
Synthetic CDOs – partial capital
Full index trades
6%
Tranched index trades
Credit linked notes
Total return swaps
5%
U PDAT E

Basket products
Asset swaps
DE R I VAT I VE S

Credit spread options


Swaptions
12%
Equity linked credit products

5%
11%
CR E D IT

V A I D Y A N A T H A N 156
Underlying reference entity
Category
Category of
of underlying
underlying reference
reference entity
entity

2006 (Expected) 2003 2%


5%
Corporate assets
7%
4% 2%
Financials
8%

22% Sovereign assets


(emerging markets)
64% Sovereign assets (non-
emerging markets)
22% Other

64% 1999
3%
U PDAT E

6% Corporate assets

9%
Financials
DE R I VAT I VE S

Sovereign assets
Corporate assets 60% (emerging markets)
22%
Financials Sovereign assets (non-
Sovereign assets (emerging markets) emerging markets)
CR E D IT

Sovereign assets (non-emerging markets) Other

Other
V A I D Y A N A T H A N 157
Credit rating of underlying reference entity
Credit
Credit rating
rating of
of the
the underlying
underlying reference
reference entity
entity

2006 (Expected) 2003 AAA – AA


AAA – AA

19%
65%
3%
Below B A – BBB
16%
13%

4% 63%
Below B A – BBB

1999 BB – B
17% AAA – AA
U PDAT E
DE R I VAT I VE S

17%
66%
0%
BB – B Below B A – BBB

17%
CR E D IT

V A I D Y A N A T H A N 158
BB – B
Tenor distribution
Maturity
Maturity

2006 (Expected) 2003 2% 7%


Over 10 years
2% 16%
Under 1 year
Under 1 year
1 – 5 years
7%
5 years
5 – 10 years 21% 5 – 10 years
21% 54% Over 10 years

1999 5% 9%
U PDAT E

9%
Under 1 year
5 years 1 – 5 years
1 – 5 years
DE R I VAT I VE S

18% 52%
5 years
41% 5 – 10 years
36%
Over 10 years
CR E D IT

V A I D Y A N A T H A N 159
Market Constraints
Constraints
Constraints in
in using
using Credit
Credit Derivatives
Derivatives

1. Lack of client
knowledge of the product

2. Regulatory constraints

3. Systems / Infrastructure

4. Pricing – lack of data


U PDAT E

5. Lack of agreed
accounting conventions
DE R I VAT I VE S

6. Lack of homogenous
documentation

7. Lack of market liquidity


and depth
CR E D IT

V A I D Y A N A T H A N 160