Credit derivatives markets

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

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... 

Credit Derivatives are a relatively recent addition to the range of financial instruments used by banks and financial institutions. However, there has been strong growth in this innovative area of the capital markets. The British Bankers Association (BBA) estimates that at the end of 2001 the global market (excluding asset swaps) accounted for over 1 trillion. The projected growth rate for the global credit derivatives market is predicted to reach a 4.8 trillion by 2004. 

Credit derivative transactions involve both a protection buyer and protection seller. Banks currently act as either buyers or sellers of credit protection in a transaction. Insurance companies are also active in the credit derivatives market as sellers of credit protection. 

The market for single-name credit default swaps has rapidly developed in volume over the past few years and represents the highest proportion of the global credit derivatives market by notional value. The credit default swap is linked to the reference entity and its obligations. 

Within the credit derivative market, a common tenor for transactions is the 5-year maturity. Credit default swaps have most liquidity at the 3-year and 5-year maturity/tenor. As a result, we often see that 5-year credit default swaps are used in structured credit transactions, such as collateralised synthetic obligations (CSOs) for this reason. Credit derivatives with a long maturity (over five years or with a short maturity (under one year) are less common. 

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. 

Asset swaps are used to alter the cash flow profile of a bond. The asset swap market is an important segment of the credit derivatives market since it explicitly sets out the price of credit as a spread over LIBOR. Pricing a bond by reference to LIBOR is commonly used and the spread over LIBOR is a measure of credit risk in the cash flow of the underlying... 

This section examines a few commercially available software packages and analytic tools designed to mitigate risk in the increasingly innovative credit derivative market. It reviews CDS data providers, examines analytic programs designed to provide expected default probabilities and theoretical prices, and highlights applications intended to simplify CDO investments. ... 

We will now turn our attention to sophisticated risk management tools. These tools are critical for companies involved in the credit derivative market. The following products are designed to produce default probabilities, the fundamental building block for effective risk management. 

An update on developments in the credit derivative market, which takes in the development of the iTraxx and CD-X indices, credit default swap trading strategies, and the 2009 big bang in the... 

Alter, Promise, 200-01 Kutner, Presidency in Peril, xviii David M. Mason, Credit Derivatives Market Solutions to the Market Crisis (Heritage Foundation Backgrounder No. 2262, April 23, 2009). 

The rapid rise in use of credit derivatives has contributed to the liquidity and depth of this market worldwide. It has also fostered the adoption of standardized terms and definitions. Terminology and definitions in credit derivative contracts have been developed and harmonized in recent years and assisted in the takeup of these products by a variety of financial and nonfinancial institutions. The need for appropriate credit derivatives definitions have been considered by the International Swaps and Derivatives Association (ISDA). ISDA s definitions and terms are used in the confirmations and termsheets for most credit derivative transactions. 

The legal department of most firms that buy or sell credit derivative instruments carefully monitor the terms of the transaction and in particular will focus on any nonstandard terms. In most cases the market will trade on standard ISDA documentation (terms and definitions). Sources of dispute, which are rare, may arise on the actual contract terms the nature of credit events, the obligation selected by the protection buyer for delivery. 

Asset swaps predate the introduction of the other instruments we discuss in this chapter and strictly speaking are not credit derivatives. However, they are used for similar purposes and there is considerable interplay between the cash and synthetic markets using asset swaps, hence the need to discuss them here. 

In Europe and Asia, the standard credit default swap contract used the restructuring definition (sometimes referred to as old restructuring ), whereas in the North American markets the standard credit default swap contracts refer to modified restructuring. The 1999 ISDA Credit Derivative Definitions would have been effective until early 2003. The 2003 ISDA Credit Derivative Definitions, which were in place in early 2003 (implementation in May 2003), have implemented some key amendments to the 1999 definitions, some of which were previously included in supplements issued by ISDA. 

Reduced form models are a form of no-arbitrage model. These models can be fitted to the current term structure of risky bonds to generate no arbitrage prices. In this way the pricing of credit derivatives using these models will be consistent with the market data on the credit risky bonds traded in the market. These models allow the default process to be separated from the asset value and are more commonly used to price credit derivatives. 

The statistical transition matrix is adjusted by calibrating the expected risky bond values to the market values for risky bonds. The adjusted matrix is referred to as the risk-neutral transition matrix. The risk-neutral transition matrix is key to the pricing of several credit derivatives. 

In practice, the spread information from the CDS market is used to imply the probability of default and the hazard rate for the underlying reference entity. The recovery rate is an input when the calculation of implied probabilities takes place. It is common to assume a recovery rate that reflects the rate on the cheapest to deliver deliverable obligation. Credit derivative traders will monitor the prices of the cheapest to deliver bonds (i.e., deliverable obligations with the lowest recovery), when constructing hedges. 

Credit default swap positions may be compared to bond positions when examining relative value of between the cash markets and the derivative markets. It is most common to compare the CDS with the bond on one of the following bases ... 

Creditex, a market-supported interdealer credit derivative broker, offers PriceTracker as a tool for accessing and monitoring CDS prices. Users have complete access to all of the live prices collected through the interdealer brokerage business. 

There are several advantages of using credit derivatives apart from generating leverage. CDS enables investors to assume credit risk in the form and denomination they choose, circumventing to a large extent the constraints on cnrrency and maturity imposed by the bond market. CDS is a cleaner vehicle to take a view on credit without taking interest rate exposure when compared to a traditional asset swap. In the event of default a CDS unlike traditional asset swaps does not leave the investor with residual swap exposure. 

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. 

Credit derivatives can be used to synthesize the economic effect of selling a bank loan short—a transaction not possible in the cash market— and do so theoretically without the risk of a liquidity or delivery squeeze, since a specific credit risk is being traded. 

To act as market makers or traders in credit derivatives. Credit derivative traders may or may not hold the reference assets directly, depending on their appetite for risk and the liquidity of the market they would need to use to hedge their derivative contracts. 

Credit-derivative pricing is similar to the pricing of other off-balance-sheet products, such as equity, currency, and bond derivatives. The main difference is that the latter can be priced and hedged with reference to the underlying asset, and credit derivatives cannot. The pricing model for credit products incorporates statistical data concerning the likelihood of default, the probability of payout, and market level of risk tolerance. 

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