--Group 7

Gaurav Gupta
Vivek Sharan
Amrita Pattnaik
Anand Wardhan
Srikant Sharma

LBSIM, New Delhi

 CREDIT RISK
It is the risk that a counterparty in financial
transaction
will fail to fulfill their obligation.

 CREDIT DERIVATIVES:
Credit derivatives are derivative instruments
that seek to trade in credit risks.
– Credit default swap

– Credit spread option

– Credit linked note

 A huge market with over $40 trillion of notional principal
 Buyer of the instrument acquires protection from the seller
against a default by a particular company or country (the
reference entity)
 Example: Buyer pays a premium of 90 bps per year for $100
million of 5-year protection against company X
 Premium is known as the credit default spread. It is paid for
life of contract or until default
 If there is a default, the buyer has the right to sell bonds with
a face value of $100 million issued by company X for $100
million (Several bonds are typically deliverable)
 90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
reference entity=100(1-R)

Recovery rate, R, is the ratio of the value of the bond issued

by reference entity immediately after default to the face value
of the bond
 Payments are usually made quarterly in arrears
 In the event of default there is a final accrual
payment by the buyer
 Settlement can be specified as delivery of the
bonds or in cash
 Allows credit risks to be traded in the same
way as market risks
 Can be used to transfer credit risks to a

third party
 Can be used to diversify credit risks
Portfolio consisting of a 5-year par yield corporate
bond that provides a yield of 6% and a long
position in a 5-year CDS costing 100 basis points
per year is (approximately) a long position in a
riskless instrument paying 5% per year
 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
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
Time Survival Expected Discount PV of
(yrs) Prob Paymt Factor Exp 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
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
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
 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.
 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
 CREDIT SPREAD:
The difference between the yield on the
borrower’s debt (loan or bond) and the yield
on the referenced benchmark such as U. S.
Treasury debt of the same maturity.
 CREDIT SPREAD OPTION
A credit spread option grants the buyer the
right, but not the obligation, to purchase a
bond during a specified future “exercise”
period at the contemporaneous market price
and to receive an amount equal to the price
implied by a “strike spread” stated in the
contract
An investor may purchase from an insurer an
option to sell a bond at a particular spread
above LIBOR credit spread.
If the spread is higher on the exercise date,
then the option will be exercised. Otherwise
it will lapse
A credit-linked note (CLN) is essentially a funded
CDS, which transfers credit risk from the
note issuer to the investor.

The issuer receives the issue price for each CLN

from the investor and invests this in low-risk
collateral.

If a credit event is declared, the issuer sells the

collateral and keeps the difference between the
face value and market value of the reference
entity’s debt
Refer to the Steel company case again.

Bank A would extend a $1 million loan to the

Steel Company.

At same time Bank A issues to institutional

investors an equal principal amount of a credit-
linked note, whose value is tied to the value of
the loan.

If a credit event occurs, Bank A’s repayment

obligation on the note will decrease by just
enough to offset its loss on the loan.
 $1 Million Instituti
onal
Bank A Institutional
investor investors
s
 Binary CDS
 First-to-default Basket CDS
 Total return swap
 Credit default option
 Collateralized debt obligation
 The payoff in the event of default is a fixed cash
amount
 Example: European option to buy 5 year
protection on Ford for 280 bps starting in one
year. If Ford defaults during the one-year life of
the option, the option is knocked out
 Depends on the volatility of CDS spreads
 Similar to a regular CDS except that several
reference entities are specified
 In a first to default swap there is a payoff when the

first entity defaults

 Second, third, and nth to default deals are defined

similarly
 Security created from a portfolio of loans, bonds, credit
card receivables, mortgages, auto loans, aircraft leases,
music royalties, etc
 Usually the income from the assets is tranched
 A “waterfall” defines how income is first used to pay the
promised return to the senior tranche, then to the next
most senior tranche, and so on.
 Tranche 1
Asset 1 (equity)
Asset 2 Principal=$5 million
Asset 3 Yield = 30%
Tranche 2
 (mezzanine)
SPV Principal=$20 million
Yield = 10%
Asset n
Tranche 3
Principal=$100 (super senior)
million Principal=$75 million
Yield = 6%
 The mezzanine tranche
is repackaged with
Subprime Mortgage other similar mezzanine
Portfolio Equity Tranche (5%)
Not Rated tranches

Equity Tranche (5%)

Mezzanine Tranche (20%)
BBB
Mezzanine
Tranche (15%) BBB
Super Senior Tranche (75%)
AAA
Super Senior Tranche
(80%)
AAA
 Between 2000 and 2006 mortgage lenders in the U.S.
relaxed standards (liar loans, NINJAs, ARMs)
 Interest rates were low
 Demand for mortgages increased fast
 Mortgages were securitized using ABSs and ABS CDOs
 In 2007 the bubble burst
 House prices started decreasing. Defaults and
foreclosures, increased fast.
 A cash CDO is an ABS where the underlying assets
are corporate debt issues
 A synthetic CDO involves forming a similar

structure with short CDS contracts on the

companies
 In a synthetic CDO most junior tranche bears

losses first. After it has been wiped out, the second

most junior tranche bears losses, and so on
 Tranche 1: 5% of principal
Responsible for losses
CDS 1 between 0% and 5%
Earns 1500 bps
CDS 2
CDS 3
Tranche 2: 10% of principal
Responsible for losses
between 5% and 15%
Earns 200 bps

Trust
Tranche 3: 10% of principal
Responsible for losses
CDS n between 15% and 25%
Earns 40 bps

Average Yield Tranche 4: 75% of principal

8.5% Responsible for losses
between 25% and 75%
Earns 10bps
 The bps of income is paid on the remaining
tranche principal.
 Example: when losses have reached 7% of the

principal underlying the CDSs, tranche 1 has been

wiped out, tranche 2 earns the promised spread
(200 basis points) on 80% of its principal