Reference assets

The first European synthetic transactions were driven by bank originators with the nnderlying reference assets being commercial loans on the originator s balance sheet. Arbitrage synthetic CDOs have also been sponsored. Within the synthetic market, arbitrage-based transaction were the most freqnently issued during 2001. 

The risk analysis for CDOs performed by potential investors is necessarily different to that undertaken for other securitised asset classes. For CDOs, the three main factors to consider are default probabilities, default correlations and recovery rates. Analysts make assumptions about each of these with regard to individual reference assets, usually with recourse to historical data. We introduce each factor in turn. 

Cash settlement represents another method of settling credit derivative transactions. In cash settlement, the protection buyer will receive an amount based on the difference between par and the valuation of the reference asset at a given valuation date, as agreed in the credit default swap contract. 

In the event of default the protection buyer would be compensated for any loss in value as a result of a credit event affecting the market value of the reference asset. 

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. 

Exhibit 21.4 illustrates a generic TR swap. The protection buyer has contracted to pay the total return on a specified reference asset, while simultaneously receiving a LIBOR-based return from the protection seller. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments include the interest payments on the underlying loan as well as any appreciation in the market value of the asset. The protection seller will pay the LIBOR-based return it will also pay any difference if there is a depreciation in the price of the asset. The economic effect is as if this entity owned the underlying asset, as such TR swaps are synthetic loans or securities. 

The total return on the underlying asset is the interest payments and any change in the market value if there is capital appreciation. The value of an appreciation may be cash settled, or alternatively there may be physical delivery of the reference asset on maturity of the swap in return for a payment of the initial asset value by the total return receiver. The maturity of the TR swap need not be identical to that of the reference asset and, in fact, it is rare for it to do so. 

Note We note that the return to the investor is influenced by the return on the underlying reference asset. 

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... 

For example, if we have a CLN that pays out a reduced amount on the event of default of a reference asset, then this CLN may be similar to a straight forward cash investment plus the sale of a credit default swap (CDS). 

Recovery rate (R) of the reference asset on default (i.e., 100 received... 

The historical volatility of the difference between the reference asset yield and the yield on a risk-free benchmark. 

Estimation of the historical volatility by considering the components historic volatility of the reference asset yield, historic volatility of the benchmark yield, correlation of the returns between the reference asset yield and the benchmark yield. 

A key issue with credit spread options is ensuring that the pricing models used will calibrate to the market prices of credit risky reference assets. The recovery of forward prices of the reference asset would be a constraint to the evolution of the credit spread. More complex spread models may allow for the correlation between the level of the credit... 

The fair value for the TRS will be the value of the spread for which the present value of the LIBOR +/- spread leg equals the present value of the returns on the underlying reference asset. The present value of the returns on the underlying reference asset may be determined by evolving the underlying reference asset. The expected value of the TRS payoff at maturity should be discounted to the valuation date. 

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. 

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... 

In a default, the swap is terminated, and the default payment is calculated and handed over. The amount of this payment may be linked to the change in price of the reference asset or another specified asset or fixed at a predetermined recovery rate. Alternatively, it may involve actual delivery of the reference asset at a specified price. 

The swap payer can reduce or remove credit risk without selling the relevant asset. In a vanilla TR swap, the total return payer retains rights to the reference asset, although, in some cases, servicing and voting rights may be transferred. At swap maturity, the swap payer can reinvest the asset, if it still owns it, or sell it in the open market. The swap can thus be... 

Related to these factors are several risks that the guarantor must take into account. One crucial consideration is the likelihood of the TR swap receiver defaulting at a time when the reference asset has declined in value. This risk is a function both of the financial health of the swap receiver and of the market volatility of the reference asset. A second important consideration is the probability of the reference asset obligor defaulting, triggering a default by the swap receiver before the swap payer receives the depreciation payment. 

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