Credit default risk

There are two main types of credit risk that a bond portfolio or position is exposed to. They are credit default risk and credit spread risk. Credit default risk is defined as the risk that the issuer will be unable to make timely payments of interest and principal. Typically, investors rely on the ratings agencies—Fitch Ratings, Moody s Investors Service, Inc., and Standard 8c Poor s Corporation—who publish their opinions in the form of ratings. 

Vol. 543 C. Benkert, Default Risk in Bond and Credit Derivatives Markets. IX, 135 pages. 2004. 

Consumers expect to have multiple credit cards and to carry balances on more than one credit account. NO Lenders only extend a certain amount of credit per person to spread default risk across multiple borrowers. Assign everyone s single credit account at birth, funded jointly by multiple lenders. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

As shown in previous sections, the credit spread on a corporate bond takes into account its expected default loss. Structural approaches are based on the option pricing theory of Black Scholes and the value of debt depends on the value of the underlying asset. The determination of yield spread is based on the firm value in which the default risk is found as an option to the shareholders. Other models proposed by Black and Cox (1976), Longstaff and Schwartz (1995) and others try to overcome the limitation of the Merton s model, like the default event at maturity only and the inclusion of a default threshold. This class of models is also known as first passage models . 

Like Black and Cox s work, the authors find spreads similar to the market spreads. Moreover, they find a correlation between credit spread and interest rate. In fact, they illustrate that firms with similar default risk can have a different credit spread according to the industry. The evidence is that a different correlation between industry and economic environment affects the yield spread on corporate bonds. Then, the duration of a corporate bond changes following its credit risk. For high-yield bonds, the interest-rate sensitivity increases as the time to maturity decreases. 

The credit spread is defined as the difference between the risky rate of a defaul-table bond and the risk-free rate of a default-free bond. In this case, with bonds priced at par, between coupon and risk-free rate, the pricing is performed like a valuation of a straight bond, including the default risk adjustment. The price is given by Equation (8.25) ... 

Following the risk neutral theory, the credit spread is not included into option valuation because it is independent from the default risk of the underlying asset. The inclusion of credit spread overvalues the option. 

Thus far our coverage of valuation has been on fixed-rate coupon bonds. In this section we look at how to value credit-risky floaters. We begin our valuation discussion with the simplest possible case—a default risk-free floater with no embedded options. Suppose the floater pays cash flows quarterly and the coupon formula is 3-month LIBOR flat (i.e., the quoted margin is zero). The coupon reset and payment dates are assumed to coincide. Under these idealized circumstances, the floater s price will always equal par on the coupon reset dates. This result holds because the floater s new coupon rate is always reset to reflect the current market rate (e.g., 3-month LIBOR). Accordingly, on each coupon reset date, any change in interest rates (via the reference rate) is also reflected in the size of the floater s coupon payment. 

Although the products typically identify with structured credit seem extensive and often confusing, reflecting the numerous underlyings that are possible bonds, loans, credit default swaps, and so on versus CBOs, CLOs, CSOs, and so on. They all achieve a very similar value proposition they are vehicles to pool and redistribute risk. In many ways, all these products are best classified as derivative instruments given that they... 

The default risk component of a swap spread will be smaller than for a comparable bond credit spread. The reasons are straightforward. First, since only net interest payments are exchanged rather than both principal and coupon interest payments, the total cash flow at risk is lower. Second, the probability of default depends jointly on the probability of the counterparty defaulting and whether or not the swap has a positive value. See John C. Hull, Introduction to Futures and Options Markets, Third Edition (Upper Saddle River, NJ Prentice Hall, 1998). 

Credit derivative products are defined by reference to underlying reference entities, and reference obligations, which include corporate bonds, bank loans, sovereign debt, Brady bonds, and Eurobonds. Credit derivatives are now used increasingly in structured transactions. For example synthetic collateralised loan obligations (see Chapter 15) often use credit default swaps to transfer credit risk from the originator to the special purpose vehicle (SPV). Currently, the most common products are credit default products and total return swaps. 

An interesting development in the credit default swap market is the response of protection sellers to credit events, the impact is ultimately reflected in the price of credit default swaps, as reflected by the credit default swap spread. Credit derivative markets have experienced spread widening at times of bad credit related news, in effect this reflects the protection sellers pricing the risk of the additional probability of a credit event into the protection they sell. 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

Various credit derivatives may be priced using this model for example, credit default swaps, total return swaps, and credit spread options. The pricing of these products requires the generation of the appropriate credit dependent cash flows at each node on a lattice of possible outcomes. The fair value may be determined by discounting the probability-weighted cash flows. The probability of the outcomes would be determined by reference to the risk neutral transition matrix. 

The pricing of credit default swaps is determined in the credit default swap market by traders who determine the credit default swap spread through their assessment of the default risk of the reference obligations. This spread information can give valuable information about the key pricing components of the reference credit implied probability of default of the reference credit and recovery assumptions. These price... 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

In the situation where the risk of a technical default risk is higher for credit default swaps than cash bonds. This results in protection sellers demanding a higher premium. For example, default swaps may be triggered by events that do not constitute a full default on the corresponding cash asset. 

Although the pricing of a credit default swap can be numerically reduced to a model, the inputs to that model still remain subjective. How can one calculate an exact valne for R, the recovery value of an issuer s assets post-default Or, more importantly, how can one calculate the hazard rate X for an issuer What is the probability that a particular issuer will default in five years Determining the true credit risk of an issuer has been a topic of intense focus in recent years and, as a result, quite a variety of methods and models have surfaced. 

The NX CR Engine is a pricing and risk management tool that allows users to model a wide range of credit derivative products. It produces theoretical prices for single-name credit default swaps, baskets and CDOs. In addition, NumeriX s software produces survival probabilities, recovery rates and correlations. 

Robert Jarrow and Stuart Turnbull, Pricing Derivatives on Financial Securities Subject to Default Risk, Journal of Finance 50, no. 1 (1995), pp. 53-86. Kamakura Risk Information Services Credit Risk Overview Kamakura s Press Release, Kamakura Launches Basel II Default Probability Service and Announces First Client, October 31, 2002. 

It overcomes the problems encountered when measuring the risk of a portfolio comprised of instruments nonlinearly dependent on the underlying factors (e.g., baskets of credit default swaps). 

As credit becomes the new buzzword in Europe, portfolio managers have to pay attention to the spread or risk premium that they receive as compensation for taking on increased default risk. 

A much easier method of generating leverage in a credit portfolio is through credit default swaps (CDS). They let investors take on or lay off default risk in an unfunded manner. Selling default protection enables one to receive the premium associated with the additional credit risk without the need to buy a bond of that entity, and in the process creates enormous leverage, especially for higher rated credits. The increased liquidity and the compression of bid/offer spreads have added to the attractiveness of this market. 

Credit-linked notes, or CLNs, are known as funded credit derivatives, because the protection seller pays the entire notional value of the contract up front. In contrast, credit default swaps pay only in case of default and are therefore referred to as unfunded. CLNs are often used by borrowers to hedge against credit risk and by investors to enhance their holdings yields. 

Asset-swap pricing is commonly applied to credit-default swaps, especially by risk management departments seeking to price the transactions held on credit traders book. A par asset swap typically combines an interest rate swap with the sale of an asset, such as a fixed-rate corporate bond, at par and with no interest accrued. The coupon on the bond is paid in return for LIBOR plus, if necessary, a spread, known as the asset-swap spread. This spread is the price of the asset swap. It is a function of the credit risk of the underlying asset. That makes it suitable as the basis for the price payable on a credit default swap written on that asset. 

Practitioners increasingly model credit risk as they do interest rates and use spread models to price associated derivatives. One such model is the Heath-Jarrow-Morton (HJM) model described in chapter 4. This analyzes interest rate risk, default risk, and recovery risk—that is, the rate of recovery on a defaulted loan, which is always assumed to retain some residual value. 

The models analyze spreads as wholes, rather than splitting them into default risk and recovery risk. Das (1999), for example, notes that equation (10.1) can be used to model credit spreads. Credit options can thus be analyzed in the same way as other types of options, modeling the credit spread rather than, say, the interest rate. 

SPV usually enters into an interest rate swap. The swap counterparty may also sell the SPV other derivative instruments, such as interest rate caps, to manage possible cash flow risk. Such risk-exposure management requires careful attention, since the SPV s risk profile can have a significant impact on the credit risk of the notes issued to investors. In an unleveraged transaction, the size of the issue is equivalent to the credit protection the SPV offers on the reference pool of assets. For example, if the credit default swap is on a nominal of 300,000, the nominal value of the notes issued will be 300,000. 

The notes issued to investors are linked to the credit risk of the portfolio through the credit-default swap— which usually has the same term to maturity as the notes—and to the credit derivative counterparty. The... 

The contingent payments under any credit-default swap used to transfer credit risk from the originator to another party, such as the SPV or an OECD bank. Under Basel 1 rules, if an investor takes out credit protection on a loan, and the protection is provided by a OECD bank, his capital charge changes from 100 percent to 20 percent. 

The sale agreement or credit-default swap agreement used to transfer credit risk... 

Crosbie, P. 1997. Modeling Default Risk. Credit Derivatives Key Issues. London British Bankers Association. 

---