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Credit Derivatives CDS CDO CLO 1709821374
Credit Derivatives CDS CDO CLO 1709821374
Credit Derivatives CDS CDO CLO 1709821374
The debt instrument can be any of these instruments viz. commercial papers,
certificates of deposit, non convertible debentures of original maturity up to one
year etc.
Risks in the CDS : Counter party concentration risk and hedging risk are the
major risks in the CDS market.
Assume that Mr.Tom owns 8% 5 year bond of face value ₹ 25 crore issued by
XYZ Ltd. Tom enters into a five year CDS contract with Jerry for a face value
of bond and agrees to pay 100 basis points (i.e.1%) of the face value of bond
annually as premium to Jerry. Here, Tom is protection buyer and Jerry is the
protection seller and XYZ Ltd. is the reference entity. If the reference entity
does not default till the maturity of the bond, the Tom (protection buyer) keeps
on paying 100 bps of ₹ 25 crore, which is ₹ 25 lakh to the protection seller
every year. On the contrary, if the credit event occurs, the protection buyer will
be compensated fully by the protection seller for the agreed amount in CDS.
The settlement of the CDS takes place either through cash settlement or
physical settlement.
▪ The assets that form the CDO are usually collected by an investment bank or
other financial institution and then sold to a special purpose entity (SPE). The
SPE is set up by the bank to purchase the assets from it. The assets are mostly
comprised of mortgage loans in the CDO.
▪ In order to fund the purchase of assets from the bank, the SPE sells
securities to investors. CDO allows investors to purchase a share of a
diversified underlying portfolio.
▪ The securities sold to investors are generally tranched, meaning that the
securities are divided into different classes or tranches* (viz. Senior, Mezzanine
and Equity) with varying risks and claims on the cash flows produced by the
underlying assets. [ *Tranches are pieces of a pooled collection of securities,
usually debt instruments, that are split up by risk or other characteristics in
order to be marketable to different investors. Tranches carry different
maturities, yields, and degrees of risk and privileges in repayment in case of
default.]
▪ The senior tranche of the CDO carry the lowest risk and hence, it receives
the low return. The mezzanine tranche of the CDO carry the modest risk &
receives the modest return. The equity tranche is the highest risk portion of the
CDO and hence, receives the higher return. Equity tranche is the first position
to bear any losses resulting from underlying asset pool and receives income
only after all other tranches of the security have been satisfied.
▪ The cash flows generated by the underlying assets are like a waterfall,
payments are prioritised first to highest tranches and anything remaining is paid
out of tranches that appear progressively lower in the hierarchy. If cash flows
from the underlying assets prove insufficient, the lower tranches are first to
suffer the losses and may not be paid at all.
Types of CDO
▪ Cash Flow CDO is a type of CDO that invests in cash generating assets
such as bonds, mortgages and loans.
▪ Synthetic CDO is a type of CDO that invests in non cash derivatives (viz.
credit default swaps, options, and other contracts) that offers extremely high
yields to investors. Unlike cash flow CDO, the synthetic CDO does not actually
have to own any underlying assets at all.
Advantages of CDO
restructuring. If the credit event does not occur before the maturity of loan, the
protection seller does not make any payment to the protection buyer.
Risks in the CDS : Counter party concentration risk and hedging risk are the
major risks in the CDS market.
Example of Credit Default Swap
Assume that Mr.Tom owns 8% 5 year bond of face value ₹ 25 crore issued by
XYZ Ltd. Tom enters into a five year CDS contract with Jerry for a face value
of bond and agrees to pay 100 basis points (i.e.1%) of the face value of bond
annually as premium to Jerry. Here, Tom is protection buyer and Jerry is the
protection seller and XYZ Ltd. is the reference entity. If the reference entity
does not default till the maturity of the bond, the Tom (protection buyer) keeps
on paying 100 bps of ₹ 25 crore, which is ₹ 25 lakh to the protection seller
every year. On the contrary, if the credit event occurs, the protection buyer will
be compensated fully by the protection seller for the agreed amount in CDS.
The settlement of the CDS takes place either through cash settlement or
physical settlement.
CLO Mechanism
▪ The procedure followed for creation of CLO and distribution of cash flows
from the underlying assets in a CLO to the investors is the same that is followed
in the case of CDO as explained the above. The difference under the CLO lies
in the underlying collateral assets. In the CDO, the underlying collateral assets
are mostly mortgage loans, whereas under the CLO, the underlying collateral
assets are first lien senior secured bank loans, which rank first in priority of
payment in the borrower’s capital structure in the event of bankruptcy, ahead of
unsecured debt.
▪ CLO portfolios are actively managed over a fixed tenure known as the
‘reinvestment period’ (3 to 5 years) during which time, the manager of a CLO
can buy and sell individual bank loans for the underlying collateral pool in an
effort to create trading gains and mitigate losses from deteriorating credits.
▪ The investors under the CLO are paid from the cashflows that the
underlying loans generate. The cashflows from the underlying loans are
prioritised and the investors at top tranche in the tranche structure are paid first.
If cash flows from the underlying assets prove insufficient, the lower tranches
are first to suffer the losses and may not be paid at all.
▪ CDOs mainly have exposure to just one industry i.e. the housing market,
whereas CLOs usually have exposure to varying industries.
▪ CLO is relatively less intricate than CDOs. CDOs make use of many
derivatives such as credit default swaps, options, while CLOs are a combination
of underlying loans depending upon the varying levels of risk.
▪ The exposure of the banking sector in CLOs is relatively lesser than CDOs.
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