Credit derivatives

Gup and Brooks (1993) noted that swaps credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. 

As noted, credit derivatives may be used by investors to manage the extra risk they take on by opting for the higher returns of non—default-free debt. The instruments can also be used, however, to synthesize the exposure itself, if, for instance, compelling reasons exist for not putting on the cash-market position. Since credit derivatives are OTC products, they can be tailored to meet specific requirements. 

AAA Aaa AAA Gilt edged, prime, maximum safety, lowest risk, and when sovereign borrower considered default-free  

1 The financial position of the company, as determined by its balance sheet and anticipated cash flows and revenues 

2 The outlook for the company s industry as whole and the competition within it 

When a technical or actual default occurs, bondholders suffer losses as the value of their assets declines or, in the worst case, disappears entirely. The extent of credit risk varies with the fiscal condition of the borrowers and the health of the greater economy. The magnitude of 

The health of the domestic economy Another indicator of credit risk is the credit risk premium the spread between the yields on corporate bonds and those of government bonds in the same currency. This spread is the compensation required by investors for holding bonds that are not default-free. The size of the credit premium changes with the market s perception of the financial health of individual companies and sectors and of the economy in general. The variability of the premium is illustrated in FIGURES 10.2 and 10.3, which show the spreads between the U.S.-dollar-swap and Treasury yield curves in February 2007 and February 2009, respectively. 

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

If this difference is positive we have a positive basis, and it happens when credit derivates trade at higher prices than asset swaps. Otherwise, if the difference is negative we have a negative basis. Consider the following example of a positive basis trade for HERIM and TKAAV. For both bonds, we calculate the CDS spread which is equal to 86.3 for HERIM and equal to 88.6 for TKAAV. The CDS basis over the ASW spread determined before is equal to 46.8 for HERIM and equal to 49.5 for TKAAV. However, the basis illustrated in Figure 1.6 is different because CRVD measures them relative to the Z-spread, which is 50.7 for HERIM and 48 for TKAAV. The basis relative to the Z-spread is equal to 35.6 for HERIM and 40.6 for TKAAV. So, we note that either the ASW spread or the Z-spread can be used as the basis performance, giving a similar result and positive basis in both cases. 

There are two basic forms of pooled commercial mortgage transactions the true sale and the synthetic structures. The true sale mechanism, as its name suggests, involves the sale of assets from the originator s balance sheet to an SPV, which are then used as security for the issue of notes to investors. Synthetic structures, by contrast, involve the creation of a credit derivative linked to the performance of a pool of loans. The loans themselves remain on the balance sheet of the originator but the credit risks associated with these loans are transferred through the credit derivative to investors. Synthetic structures can simplify the issuance process and avoid many of the complexities (and costs) associated with the sale of assets in many jurisdictions. 

In-depth coverage of credit derivatives is given in Chapter 21. 

In this section we will attempt to complement the theory and approaches discussed so far with actual transaction examples. Specifically, we will highlight Euro Zing I CDO as a further example of the flexibilities a CDO s liability structure can adopt. Equally, we will explore the use of indexation in CDO structures with the Rosetta CBO I transaction. And finally, Robeco CSO III will be examined as the first fully managed, standalone CDO backed by credit derivatives. 

Impacts on the credit derivative market Introduction of a new type of risk counterparty in the credit derivatives market that has the capacity to sell protection on large portfolios of risk, increasing the capacity... 

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