Credit seller

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We assume we have constructed a market curve of Libor discount factors where Df(t) is the price today of 1 to be paid at time t. From the perspective of the asset swap seller, it sells the bond for par plus accrued interest. The net up-front payment has a value 100 F where P is the market price of the bond. If we assume both parties to the swap are interbank credit quality, we can price the cash flows off the Libor curve. 

Mortgage master trusts require the seller to maintain a certain minimum interest in the collateral pool held by the master trust. In credit card transactions this is used to absorb the monthly fluctuations in the balance outstanding on the credit cards and ensure there is always sufficient collateral to support the notes. In RMBS transactions the minimum seller s interest tends to be smaller as the mortgages have a more stable repayment profile, and this is primarily available to cover set-off risk in the event of originator insolvency. In existing transactions it is the minimum trust size rather than the minimum seller s share that has been the key constraint. 

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 most common form of settlement chosen is physical settlement, in this situation the buyer of protection will deliver the defaulted asset or other assets that are pari passu with the reference obligation—effectively the asset delivered is covered by the credit default swap contract—to the seller of protection for par value (in cash). 

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. 

In some versions of a TRS the actual underlying asset is actually sold to the counterparty, with a corresponding swap transaction agreed alongside in this type of TRS, the protection seller will make an upfront payment for the market value of the reference asset to the protection buyer. Yet another variation involves no change in physical ownership but still involves an upfront payment of the market value of the reference asset an example of this kind of TRS is described in Exhibit 21.4. On occurrence of a credit event the TRS will be terminated using physical settlement, so that the reference asset is delivered to the protection seller. 

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. 

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. 

In a credit default swap, the protection buyer is effectively long a delivery option. This delivery option gives the protection buyer the opportunity to deliver the cheapest to deliver asset to the protection seller. 

The buyer of protection pays to the seller a periodic premium, often quarterly, and expressed on a per annum basis. The actual cash amounts of all future premium payments are always known, since the terms of the default swap are set on the trade date. Therefore, we can think of these payments as a series of cash flows and value them according to the method above. We define d to be a function representing the number of calendar days since the inception of the default swap. We then define an integer variable / to represent each premium payment date, such that d is a function of /, d(j). Time is also a function of /, and that is simply the number of years from t = 0 until t = j For our sample 2-year credit default swap, the dates are shown in Exhibit 22.2. 

Perhaps the most important part of the default swap is the payment the buyer of protection will receive if a default occurs during the life of the swap. After all, this is precisely the protection the buyer is paying for. Upon a default, the buyer of protection will receive the notional amount of the swap after delivering to the seller-defaulted assets of the issuer. We define recovery value, or more briefly R, to be the value of these defaulted assets immediately following the credit event, so it can be more easily stated that upon a default the buyer of protection will receive 100% - R. 

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. 

The most common credit derivative, and possibly the simplest, is the credit default swap—also known as the credit or default swap. As diagrammed in FIGURE 10.4, it is a bilateral contract in which a protection seller, or guarantor, in return for a periodic fixed fee or a onetime premium agrees to pay the beneficiary counterparty in case any of a list of specified credit events occurs. The fee is usually quoted as a percentage of the nominal value of the reference asset or basket of assets. The swap term does not have to... 

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. 

Practices such as drop-shipping (Netessine and Rudi 2001(a,b)) separate the selling task from the physical or financial ownership of material, so that the seller becomes essentially an order-taker. For example, a book ordered from Amazon.com might travel directly from the book distributor to the end customer, with activity initiated only after Amazon has assured payment from the customer s credit card company. Monitors in Dell s orders are shipped directly from Sony s warehouses to the end customer without ever passing through Dell-owned facilities. A related development is exemplified by the option for Amazon.com s customers to pick up certain purchases (and make returns later if necessary) at a local Circuit City store, which was introduced in late 2001. 

Transaction costs Transaction costs close related to trust and reputation in buyer-seller relationships. Guanxi accelerates problem solving and increase problem tolerance in relationships with international customers which enhance long term business success. Thus transaction costs in international markets are lower than in domestic markets for higher level of trust and creditability of reputations which lead to less information and enforcement costs. 

All monetary objects credit cards as much as bank notes and eoins - are material things that can be considered as economic devices or eeonomic agencements (Muniesa et al. 2007 Mcfall 2009). At its simplest, this means that a monetary object like many objects and processes - renders things, behaviors and processes economic (Muniesa et al. 2007 3). They do not do so alone, however. The success of the particular object inserted between the economic exchange of an ideal typical buyer and seller is dependent on the security and predictability of its relationship with a diverse and complex range of associated actors, both human and non-human. 

In essence, the seller s accounts receivable are purchased by the bank at a discount. The bank advances less than 100% of the face value of the receivable even though it takes ownership of the entire receivable. The difference between this advance amount and the invoice amount creates a reserve, and may be used to cover any deficiencies in the payment of the invoice. When the invoice is paid in full by the buyer, the reserve amount is remitted to the seller. The credit rating of the buyer, which usually exceeds that of the seller, is often used to determine the finance-rate offered. The seller s cost of capital is thus reduced. 

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