Credit Derivatives ?

Part II Page 1 of 5

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Thu, 24-Oct-2002 17:14:06
Credit Derivatives ? Part II IST (GMT+5:30)

Jargon Management Credit Derivatives – Part II

Now that we have a brief introduction into what a credit

Student Speak derivative is, let us take a closer look into two of the
popular credit derivative instruments.
Damagement lessons
A. Credit Default Swaps

Cyber Trek Credit Default swaps bear a close resemblance to

financial guarantees. Financial guarantees make good
General Management any loss arising due to default of payment. However,
credit default swaps go a step further and enable the Message Boards
lender to be protected against other events such as a
Operations Management credit downgrade, apprehended default etc. Post a message

In a default swap, the seller of protection pays a

Financial Management predetermined amount in case the default event arises. Quick Search
In return, the buyer of protection, pays an upfront or Enter IIL company code
HR Management periodic premium to the seller of protection.

Mechanism of a default swap

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Entrance Guide

In case of a credit event, pay the predetermined amount

Career Guide
Example: Assume Bank A has an exposure to XYZ
Placement Guide Co. However, it is worried that since the project of
XYZ Co. has run into rough weather, the credit rating Drop us a line
of the company might go down. Hence, it approaches Drop us your queries &
Case Studies Quiz Bank B and negotiates with it to enter into a credit suggestions
default swap. Bank A pays Bank B a periodic
payment, while Bank B agrees to pay a certain
Entrepreneur MBA amount should XYZ Co. be downgraded.

About us It is a win-win situation for both, since

l Bank A is protected against credit downgrading,

Disclaimer which in turn reduces the risk profile of its

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Credit Derivatives ? Part II Page 2 of 5

investment. This releases some capital of Bank A

which can be invested in more lucrative sectors.
l Bank B has gained exposure into a company,
which until date was not available to it. It also
earns a fee or premium, hence increasing non-
fund based income.

Issues to be considered in a default swap

I. Choice of a default protection seller

When an investor is buying a default protection, what

kind of a default protection seller should one look for.
Given a ceteris paribus condition, one would look for a
seller with a AAA rating to prevent a default by the
counter party. However such a counter party would sell a
very expensive protection. Hence it would be better to
look for a counter party with a lower rating and hence
secure a cheaper seller.

While the credit rating of the seller is important, it is

equally important to look for a seller who has the least
correlation with the protection seller, since this would
avert a joint default by both the issuer and the seller.

Hence to summarize, the characteristics to look for in a

seller are:

l Credit rating of the seller

l Correlation between the seller and the issuer of

the reference asset

II. Hedging using a different reference entity

To hedge the risk of a loan, the credit protection buyer

does not have to acquire protection only for that asset.
He can hedge the credit risk of another entity and define
credit event in terms of a default of that entity.

Consider the example of a bank willing to lend to a

company in Argentina. But the bank is worried that
political risks, labor strikes etc. will disrupt the business of
the company. Hence the bank can buy protection for a
different asset, say the Govt. of Argentina bonds (which
the bank has never purchased). Under the credit default
swap agreement, the credit event is defined in terms of
all those events that can disrupt the economy. Hence if
these conditions occur, the seller of protection is to make
good the difference in the value of the bonds in
comparison to its par value. The important point to be
noted here is that, at the time of the occurrence of such a
credit event, even though the Argentinean Govt. may not
default, the value of the bonds will fall, leading to the
seller making good this difference. This difference will set
off the loss incurred by the banker in the form of default

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Credit Derivatives ? Part II Page 3 of 5

by the company , whose business would have been

disrupted by the credit events.

All is not hunky-dory when one sees this brilliant

application of credit derivatives on a different reference
entity. It is important to establish a correlation between
the loan and the other reference asset, if the defined
credit event arises.

Total Rate of Return Swaps

As the name implies, in a total rate of return swap, the

total return obtained from the asset is passed on to the
protection seller, in return for a fixed pre-determined
amount paid periodically.

Mechanism of a TRORS

Strictly speaking, a TRORS falls beyond the definition of a

credit derivative since it offers protection against other
risks as well. This is because, the total return of a credit
asset can be affected by various factors, some of which
may be quite extraneous to the asset in question, such as
interest rate movements, exchange rate fluctuations etc.
Nevertheless, the protection seller here guarantees a
prefixed return to the buyer, who in turn, agrees to pass
on the entire collections from the credit asset to the
protection seller. That is to say, the protection seller offers
protection against market risk, credit risk, interest rate
risk, foreign exchange risk etc.

Reasons why a seller sells protection

The most important reason why an investor sells

protection under a TROR is to take advantage of
leverage. That is to say if the investor is funded by a
bank, and at the maximum has to issue a collateral, his
return is very high.

To illustrate, a numerical example is given below.

Assume there are two investors, one who pays using

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Credit Derivatives ? Part II Page 4 of 5

cash and another using leverage (borrows from the

bank). The investor who has the advantage of borrowing
from a bank the amount needed to finance the derivative,
however will have to retain a collateral with the bank, on
which the bank will pay interest. Let us assume that the
investor using leverage will have to maintain a 5%
collateral.

The reference asset pays MIBOR+ 200 bps, which is

currently 10%. The funding cost for the hedge funds is
MIBOR + 50 bps.

On the collateral (which could be cash held in the bank),

the bank pays MIBOR flat as interest.

Hence the earnings for the leveraged investor is both

from the reference asset as well as from the bank in the
form of interest on collateral.

Investor with leverage Investor without

leverage
Asset’s yield 10% 10%
MIBOR 8%
Financing cost 0.5%
Net spread 10 - 8 - 0.5 = 1.5%
Collateral 5% of Total amount
Leverage (Debt/Equity) 20 : 1 1:1
Return on leveraged 1.5 / 0.05 = 30%
swap
Interest on collateral 8
Total return 30 + 8 = 38% 10%

Other reasons why an investor would want to receive

TRORS

1. They can create new assets with specific maturity

not currently available in the market.
2. They gain off-balance sheet exposure to a desired
asset such as a syndicated loan or a high yield
bond, which they would not have otherwise had
access to.
3. They can fill in the credit gaps in their portfolio. For
e.g. if the investor had an exposure only to A-rated
and AAA-rated bonds, and if they wanted to have
an exposure to AA-rated bonds as well, this
method would help them.
4. They can reduce their administrative costs, since
buying a loan on to their balance sheet would
otherwise cost them a lot.
5. They can access entire asset classes by receiving
the total return on an index.

Reasons why a buyer of protection enters into a

contract of TROR S

In case the lender of loan or the holder of a bond wants

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Credit Derivatives ? Part II Page 5 of 5

to sell or go short on the asset, he can hedge a long

position by paying the total return and receive a fixed
sum in return. In fact, this can be modified in cases when
the payer feels that he needs to hedge his position only
for a short while (i.e. the spread will widen only for a short
while), after which he feels that the asset will recover,
then he can enter into a TROR for a short while.

Sangeetha K.S.,
IIM Indore

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