Credit risk exposure

A credit-linked note (CLN) is a structured note that combines both a debt instrument and a credit derivative. The structured note includes an embedded credit derivative that isolates the credit risk of the reference asset in this way an investor in this type of structured note may be able to transform its credit risk exposure. The investor in this note makes a cash investment in a bondlike instrument and receives a return that is... 

Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered because of credit events. The loan or bond carrying the credit risk in question is the ref-... 

Note that CSOl refers to the credit risk exposure of a CDS position, meaning the change in value of the CDS contract for a 1 basis point change in credit spread. 

Double credit risk is a particular feature of such synthetic transaction structures. Not only are investors exposed to the performance of the reference pool of commercial mortgages, but also to the performance of the collateral the issuer is holding. If this includes notes issued by the originator itself then this will also include exposure to the credit rating of the originator. 

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. 

CLNs provide an excellent window to create securities bearing the maturity, currency and credit risk one would like to take on, unconstrained by the availability of the bond in the marketplace. For example, in the auto sector one of the stronger names is BMW, but the company does not have many bonds outstanding. However, the name is a very liquid in the default swap market. Therefore, for investors who want exposure to the name would find it easier to gain it by buying a CLN. 

The motivations behind the development and use of more exotic, structured notes are varied. They include the desire for increased yield without additional credit risk, as well as the need to alter, transform, hedge, or transfer risk exposure and modify risk-return profiles. These instruments have been issued by banks, corporate institutions, and sovereign authorities. They can be tailored to particular risk profiles and enable investors to gain exposure to different markets, sometimes synthetically, that they have previously been unable to access. For instance, by purchasing structured notes, investors can take positions reflecting their views on exchange rates... 

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. 

For instance, bank loans are often deemed unattractive as investments because of the administration that managing and servicing a loan portfolio requires. Investors can acquire exposure to bank loans returns while avoiding the administrative costs through, say, a total return swap. The same transaction allows banks to distribute their loan credit risk. 

The index tranche product is an OTC derivative market and a pure synthetic form of corporate credit CDO exposure. The tranche market has been established so that the trade is a bilateral contract between the dealer and the investor. The term single tranche synthetic CDO is often used to describe an index tranche exposure. However, as a result of the contract, the dealer is exposed to the risk (credit, market, and operational) of managing the contract. 

The payoff on the index tranche product is driven by the amount of realized portfolio loss that has eroded the tranche width. The tranche exposure is defined by the attachment point and detachment point. The attachment point is a lower percentage than the detachment point, and the difference is referred to as the tranche width. For reference portfolio losses that are below the attachment point there is no realized loss to the tranche notional. If losses exceed the detachment point, then the tranche notional is completely eroded. When portfolio losses lie between the attachment and detachment point there is a fractional loss to the index tranche. The buyer of protection (short credit risk) pays a premium or coupon leg that is based on the notional outstanding of the tranche. The seller of protection (long credit risk) makes contingent payments dependent on the amount of loss that has written down the tranche. 

The credit rating of a company is a major determinant of the yield that will be payable by that company s bonds. The yield spread of a corporate bond over the risk-free bond yield is known as the default premium. In practice, the default premium is composed of two elements, the compensation element specific to the company and the element related to market risk. This is because, in an environment where the default of one company was completely unrelated to the default of other companies, the return from a portfolio of corporate bonds would equal that of the risk-free bond. The gains from bonds of companies that did not default compensated for the loss from those that did default. The additional part of the default premium, the risk premium, is the compensation for risk exposure that cannot be diversified away in a portfolio, known as systematic or non-diversifiable risk. Observation of the market tells us that in certain circumstances, the default patterns of companies are related for example, in a recession there are more corporate defaults, and this fact is reflected in the risk premium. 

Inflation derivatives are an additional means by which market participants can have an exposure to inflation-linked cash flows. They can also improve market liquidity in inflation-linked products, as an earlier generation of derivatives did for interest-rates and credit risk. As flexible OTS products, inflation derivatives offer advantages over cash products in certain circumstances. They provide ... 

Tools are available to assist in comparing the risk associated with two or more different processes. For example, the first sheet of the Dow Fire and Explosion Index (FEI) (Dow, 1994b) ranks the safety characteristics of the process from a fire/explosion standpoint, without taking credit for protective and mitigation features. The Dow Chemical Exposure Index (CEI) (Dow, 1994a) and Id s Mond Index (ICI, 1985 Tyler, 1985) are other ranking tools. 

Obviously, an important component of risk communication is if you do not know an answer or are uncertain, acknowledge it and do not hesitate to admit mistakes or disclose risk information. The Centers for Disease Control, to their credit, did admit they made mistakes about the information they supplied initially about anthrax, during the anthrax exposures to postal workers during October 2001. They stated that only workers who opened the letters contaminated with anthrax were at risk. It turned out that the spores could migrate out of the unopened letters, which ended up exposing other postal workers. 

Where credit exposure is spread across geographic and industry sectors, the risk associated with localised events or problems in any individual sector will be much reduced. Where concentrations do exist, it is important to understand the underlying factors that will affect the performance of those loans. 

Taking concentration risks one step further, it is not uncommon for a portfolio to have a single loan that accounts for 10% or more of the overall portfolio. Where this is the case, investors should consider the credit fundamentals of this exposure separately in a manner similar to that used for a single-property transaction. 

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