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CREDIT DERIVATIVES
Sankarshan Basu
Example: Valuation of a Credit Default Swap
Valuation Example
• Conditional on no earlier default a reference entity
has a (risk-neutral) probability of default of 2% in
each of the next 5 years. (This is a default intensity)
• Assume payments are made annually in arrears, that
defaults always happen half way through a year, and
that the expected recovery rate is 40%
• Suppose that the breakeven CDS rate is s per dollar
of notional principal
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Unconditional Default and Survival Probabilities
Time Default Survival
(years) Probability Probability
1 0.0200 0.9800
2 0.0196 0.9604
3 0.0192 0.9412
4 0.0188 0.9224
5 0.0184 0.9039
Calculation of PV of Payments
(Principal=$1)
Time (yrs) Survival Expected Discount PV of Exp
Prob Paymt Factor Pmt
1 0.9800 0.9800s 0.9512 0.9322s
2 0.9604 0.9604s 0.9048 0.8690s
3 0.9412 0.9412s 0.8607 0.8101s
4 0.9224 0.9224s 0.8187 0.7552s
5 0.9039 0.9039s 0.7788 0.7040s
Total 4.0704s
Present Value of Expected Payoff
(Principal = $1)
Time Default Rec. Expected Discount PV of Exp.
(yrs) Probab. Rate Payoff Factor Payoff
0.5 0.0200 0.4 0.0120 0.9753 0.0117
1.5 0.0196 0.4 0.0118 0.9277 0.0109
2.5 0.0192 0.4 0.0115 0.8825 0.0102
3.5 0.0188 0.4 0.0113 0.8395 0.0095
4.5 0.0184 0.4 0.0111 0.7985 0.0088
Total 0.0511
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PV of Accrual Payment Made in Event of a
Default. (Principal=$1)
Time Default Expected Disc PV of Pmt
Prob Accr Pmt Factor
0.5 0.0200 0.0100s 0.9753 0.0097s
1.5 0.0196 0.0098s 0.9277 0.0091s
2.5 0.0192 0.0096s 0.8825 0.0085s
3.5 0.0188 0.0094s 0.8395 0.0079s
4.5 0.0184 0.0092s 0.7985 0.0074s
Total 0.0426s
Putting it all together
• PV of expected payments is
4.0704s+0.0426s=4.1130s
• The breakeven CDS spread is given by
4.1130s = 0.0511 or s = 0.0124 (124 bps)
• The value of a swap negotiated some time
ago with a CDS spread of 150bps would be
4.1130×0.0150-0.0511 or 0.0106 times the
principal.
Binary CDS
• In our example the PV of the expected payoff
for a binary swap is 0.0852 and the breakeven
binary CDS spread is 207 bps
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Implying Default Probabilities from CDS spreads
• Suppose that the mid market spread for a 5 year
newly issued CDS is 100bps per year
• We can reverse engineer our calculations to conclude
that the default intensity is 1.61% per year.
• If probabilities are implied from CDS spreads and
then used to value another CDS the result is not
sensitive to the recovery rate providing the same
recovery rate is used throughout
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Total Return Swaps
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Total Return Swap
Including interest
payments and cap.
appreciation
Total return
TR payer TR receiver
LIBOR + spread
Fixed coupon
Third party reference
asset
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Total Return Swap
• Agreement to exchange total return on a
corporate bond for LIBOR plus a spread
• At the end there is a payment reflecting the
change in value of the bond
• Usually used as financing tools by companies
that want an investment in the corporate bond
Total Return on Bond
Total Return Total Return
Payer Receiver
LIBOR plus 25bps
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TRS (Cont…)
• In a TRS one party agrees to pay the realized
total return on a reference asset
– The other party pays a floating return such as
LIBOR (plus a spread)
• The two parties merely exchange the
difference between the two rates
– The party paying the return on the reference asset
is termed as
• The Total Return Payer
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TRS (Cont…)
• There will be multiple settlement dates during
the life of the swap
• From the standpoint of the total return payer
– He is short the reference asset
– And long in the asset paying the floating rate
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Total return swap
• TR payer
– strips out all economic exposure - both credit and
market risk - to the underlying asset
– does not sell it at the open market
– continues to carry it on balance sheet
• TR receiver
– gets exposure to the underlying asset
– financing cost potentially lower than market rates
– does not carry on balance sheet - off B/S
• No specific credit event
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Total Return Swaps
• TR payer
– typically lenders/investors wanting to reduce
exposure to an asset
– by TR swap, client confidentiality is maintained
unlike in case of loan sale
– does not necessarily have to hold asset on B/S
• shorting the asset synthetically
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TR swaps
• TR receiver
– typically insurance co., hedge funds, corporate
treasurers
– lock in term financing rates and effectively create
repurchase agreements
– no administrative burden of owning the asset
– financial interests:
• portfolio diversification
• yield enhancements
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TR swap - yield enhancements
• Asset: $10m exposure to an outstanding bank
loan paying LIBOR + 250bps
• TR receiver pledges $1m against underlying asset
• Bank - TR Payer: Pays LIBOR + 250bps
• Investor - TR Receiver: Pays LIBOR + 100bps
• Financing spread : 150bps
• Yield on pledged amount : 6% of $1m
• Total yield on pledged amount:
= (150bps x 10) +6% = 21%
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TR swap - yield enhancements
• Downside
– Default of loan (reference asset)
– Recovery rate = 90% of $10m = $9m
– Loss = $10m - $9m = $1m
– Capital pledged = $1m
– Entire capital is wiped out.
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TR swap - freeing up credit lines
• Commercial bank exhausts internal credit
limits to a borrower
• Need to increase exposure further to keep
relationship
• Use TR swap to reduce exposure to client
• Frees up corresponding credit lines
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Illustration
• A fund is long in the S&P500 Index to the
extent of 5MM USD
– It wants to reduce its exposure to 2.50MM
– One way is to sell half the portfolio
– An alternative is to transfer the returns from one-
half of the portfolio by entering into a TRS
– The fund will have to pay the total return
(dividends + capital gains) on the index
– In return for LIBOR on the 2.50MM
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Illustration (Cont…)
• Consider the following return profile for the
S&P500 Index over a four year period
Year Capital Gain Dividends Total Return
1 6.50% 2.25% 8.75%
2 2.25% 2.25% 4.50%
3 -8.25% 2.25% -6.00%
4 12.50% 2.25% 14.75%
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Illustration (Cont…)
• Assuming the LIBOR rates shown in the table,
the payments by the total return payer will be
Year LIBOR Net Payment to
TR Payer
1 7.75 -1.00%
2 7.00 2.50%
3 7.25 13.25%
4 7.40 -7.35%
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Motives for TRS
• It can be used as a tool for managing credit
risk
– A fund manager holding corporate bonds can
swap the return from the bond for a floating rate
– If the issuer were to default the manager will
receive a payment on the swap
– This will compensate for the fact that the bond is
worth only a fraction of its face value
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Example: Valuation of a Total Return Swap
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Example
Bank One has made a $200 million loan to a software company
at a fixed rate of 12%. The bank wants to hedge its exposure by
entering into a total return swap with a counterparty, Interloan
Co., in which Bank One promises to pay the interest on the loan
plus the change in the market value of the loan in exchange for
LIBOR plus 40 basis points. If after one year the market value of
the loan has decreased by 3% and LIBOR is 11%, what will be the
net obligation of Bank One?
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Example: Solution
• Outflow: 12% - 3% = 9%
• Inflow: 11% + 0.4% = 11.4%
• Net receipt: 11.4% - 9% = 2.4%
• Notional principal: $200 million
• Thus, net receipt is:
$200 million *2.4% * 1 year = $4.8 million.
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Credit Options
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Credit Options
• Credit spread = yield of security or loan minus
yield of corresponding risk free security
• credit quality improvement leads to credit
spread decreases
• credit quality deterioration leads to credit
spreads increasing
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Credit Options
• Underlying reference value:
– price of asset
• used mostly for floating rate notes
• Price option - in the money if bond price falls below
strike price
– level of credit spread
• used mostly for fixed rate notes
• Spread options - in the money if spread is higher than
benchmark
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Credit Linked Notes (CLNs)
• CLNs - risk tranfer using a credit swap to be
embedded into a security and issued to an
investor.
• Issuer sets up AAA SPV
• SPV sells default protection to third
counterparty in return for premium
• Investors in CLN get larger coupon
(inclusive of credit swap premium) in return
for lower payments in case of credit event.
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Credit Options
• A credit call option gives the buyer the right to
purchase the underlying credit sensitive asset
or credit spread
– At a specified price and time
• A credit put option gives the buyer the right to
sell the underlying credit sensitive asset or
credit spread
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Illustration
• An investor believes that the credit spread for
an asset or basket will widen over the next six
months
• He can buy a six month call on the spread by
paying a premium
– If the spread widens beyond the strike price the
option will be In-The-Money
– Else the investor will forfeit the premium
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Collateralized Debt Obligations
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Collateralized Debt Obligation
• A pool of debt issues are put into a special purpose
trust
• Trust issues claims against the debt in a number of
tranches
– First tranche covers x% of notional and absorbs first x% of
default losses
– Second tranche covers y% of notional and absorbs next
y% of default losses
– etc
• A tranche earn a promised yield on remaining
principal in the tranche
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CDO Structure
Tranche 1
Bond 1
1st 5% of loss
Bond 2
Yield = 35%
Bond 3
Tranche 2
2nd 10% of loss
Yield = 15%
Trust
Tranche 3
3rd 10% of loss
Bond n Yield = 7.5%
Tranche 4
Average Yield
Residual loss
8.5%
Yield = 6%
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Synthetic CDO
Instead of buying the bonds the arranger of
the CDO sells credit default swaps.
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Conclusion
• Credit derivatives separates credit risk from
other risk and facilitates trade in credit risk
• Several types of credit derivatives
• Market is still in its infancy but has a huge
potential given that credit risk is the largest
risk exposure for the biggest financial
institutions.
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