A series designed to provide a quick tour of the quantitative tools used in today's financial services industry.
This is the first of three articles on credit derivatives, how they are valued by the market, and implications for bank portfolio management.
While "credit derivatives" is still a new term for many of us, derivative contracts on credit have been around a long time. Bond insurance, which has existed for more than 20 years, is essentially an option that pays in the event of default on a particular bond. In addition, many traditional banking products could be thought of as credit derivatives, even though they are not generally labeled as such. For example, a letter of credit is an option on the creditworthiness of a borrower, and a revolving credit facility includes an option on the borrower's credit spread.
Notwithstanding the fact that traditional credit products have derivative elements, the term "credit derivative" generally relates to the over-the-counter markets for total return swaps, credit default swaps, and credit-linked notes, a market that dates from approximately 1991.
Credit derivatives transfer credit risk from one counterparty to another. This simple statement requires us to consider the source of the risk and the method of transfer. Both of these are summarized in Figure 1.
As seen in the bottom half of Figure 1, the source of the transferred credit risk can be a single asset-specific corporate bonds, loans, sovereign debt, or the credit risk arising from another derivative (for example, an interest rate swap)--or a pool of assets. If the pool is small and the assets are specifically listed in the contract, then the pool is referred to as a basket. Larger portfolios can be identified through characteristics of the underlying pool of loans or receivables.
Once the underlying source of credit exposure is identified, there must be a mechanism for transferring the credit exposure. The top half of Figure 1 shows the transfer methods through a taxonomy of the credit derivative products, distinguished by the cash flow "driver."
Total Return Swap
Among the "asset return products," the most widely used is the total return swap (TRS). At origination, the parties agree on a reference asset, typically a bond or a loan that trades in the secondary market, and a reference rate. During the life of the swap the purchaser (total return receiver) receives all the cash flows on the reference asset from the seller. In exchange the purchaser pays the reference rate (typically Libor) plus or minus an agreed spread to the seller. At maturity of the swap, the counterparties revalue the reference asset. If it has appreciated, the seller of the TRS pays the appreciation to the purchaser; if it has depreciated, the purchaser pays the depreciation to the seller. Since the purchaser of the TRS receives all of the cash flows and benefits (losses) if the value of the reference asset rises (falls), the purchaser is synthetically "long" the underlying reference asset during the life of the swap.
A key element of the total return swap is that both market risk and credit risk are transferred. It does not matter whether the asset depreciates in value because the borrower's credit quality declines, credit spreads widen, or underlying interest rates increase. If there is a default on the underlying asset during the life of the TRS, the parties will terminate the swap and make a final payment. Either the TRS will be cash settled, in which case the asset is marked to market, or physically settled, in which case the seller delivers the defaulted asset to the purchaser against receipt of the reference asset's
price at origination of the swap.
Credit Default Swap
The credit default swap is the building block for all credit-event products. The buyer of a credit default swap pays a premium (either lump sum or periodic) to the …