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What is Credit Risk?
What are Credit Derivatives?
Why Credit Derivatives?
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Credit Default Swap (CDS)
Collateralized Debt Obligations (CDOs)
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j Credit risk is the risk of financial loss due to a

reduction in the credit quality of a debtor.

j Types of credit risk: Default Risk and Credit

Deterioration Risk.

j Default Risk is the risk that an obligor does not repay

part or his entire financial obligation.

j Credit deterioration risk is the risk that the credit

quality of the debtor decrease.


  


j `inancial instruments designed to transfer credit risk

from one counterpart to another.
j Legal ownership of the reference obligation is
usually not transferred.
j Credit Derivatives allow an investor to reduce or
eliminate credit risk or to assume credit risk.
j `rom a more technical point of view, credit
derivatives are financial instruments, whose value is
derived from the credit quality of an underlying
obligation.
   


The main reasons for the rise of credit derivatives are:

j The general desire to reduce credit risk in the

financial markets, expressed by increased regulatory
requirements as the Basel II Accord.

j An increase in personal bankruptcies and recent

corporate and sovereign bankruptcies.

j An increase in the ability to value and manage credit

risk.
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j The Latin American Debt Crisis

j The Saving and Loan Crisis
j The Asian `inancial Crisis
j The Russian Debt Crisis
j Argentinean Crisis
j The Enron Bankruptcy `iling
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What is a credit default swap?

j Like any swap, the CDS is an exchange of two

payments: on the one hand a fee payment and on the
other a payment that only occurs if a credit event occur.

j A default swap is similar to knock-in put option.

j Default Swap buyer has a short position in the credit

quality of the reference obligation and vice versa.
 
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jedging
jYield Enhancement
jConvenience & Cost Reduction
jArbitrage
jRegulatory Capital Relief
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j Buying a default swap means buying protection

whereas selling a default swap means selling
protection or assuming risk.

j The default swap premium, also called fee, price or

fixed rate, is often referred to as the default swap
spread.
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j Bankruptcy
j `ailure to pay
j Obligation Acceleration
j Obligation Default
j Repudiation/Moratorium
j Restructuring
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· * [Reference
Price ± (`inal Price +Accrued interest on reference
obligation)]

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· * Reference Price
 

  


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A1m
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 Treasury Bond, Yield 5% 

A1m

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Corporate Bond, Yield 8%


A1 m in case of default 3% p.a.




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Time Recovery Value `ee to protection Contingent payment to ·et Cash `low to
seller protection buyer Protection Buyer
6 months ·A A5 A0 -A5

12 months ·A A5 A0 -A5

18 months ·A A5 A0 -A5

24 months ·A A5 A0 -A5

30 ·A A5 A0 -A5
MO·TS
36 months A 400 A5 - A 600 A 595

Total A 570
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l Binary or Digital Default Swap

l Basket Credit Default Swap
l Cancelable Default Swap
l Contingent Default Swap
l Leverage Default Swap
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l A CDO gathers reference assets such as loans,

bonds, or other debt instruments and sell of pieces
of interests from the pool or tranches to investors.

l Depending on which type of debt instrument the

CDO holds, it can also be referred to as a
Collateralized loan obligation (CLO), a Collateralized
bond obligation (CBO), or a Collateralized mortgage
obligation (CMO).
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l Ramp-up period

l Cash-flow period

l Unwind period
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l Balance Sheet Motivated CDOs

l Arbitrage Motivated CDOs

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l A special purpose vehicle (SPV) with securitization

payments in the form of tranches. A collateralized debt
obligation squared (CDO-squared) is backed by a pool
of collateralized debt obligation (CDO) tranches.

l This is identical to a CDO except for the assets

securing the obligation. Unlike the CDO, which is
backed by a pool of bonds, loans and other credit
instruments; CDO-squared arrangements are backed
by CDO tranches.
  

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l The economy was at risk of a deep recession after the

dotcom bubble burst in early 2000 and September 11
terrorist attacks.
l Central banks around the world tried to stimulate the
economy by creating Liquidity.
l Lenders approved subprime mortgage loans to
borrowers with poor credit.
l Consumer demand drove the housing bubble to all-
time highs in the summer of 2005, which ultimately
collapsed in August of 2006.

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l Increased foreclosure activity.

l Declaration of Bankruptcy by large lenders and

hedge funds.

l `ears regarding further decreases in economic

growth and consumer spending.
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l Lenders
l omebuyers
l Investment Banks
l Rating Agencies
l Investor Behavior
l edge `unds
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l Biggest Culprit: Lent funds to people with

poor credit and a high risk of default
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l Adjustable-Rate Mortgage (ARM 2/28 and 3/27).

l Low introductory rates and minimal initial cost.

l ome buyers believed that the value of their homes

will appreciate continuously.

l ousing bubble burst, and prices dropped rapidly

forced home buyers to default on their mortgage.
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l Increased use of secondary Mortgage Market

increased the subprime loan lenders.

l Lenders were able to simply sell off the mortgages in

the secondary market and collect the originating fees
which freed up more capital for lending.

l Demand for these mortgages increased because of

the creation Collateralize Debt Obligation (CDO).
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l Credit rating agencies and bond insurers played

major roles in the disconnect between the true credit
quality and promised performance of the securities.
l If the ratings had been more accurate, fewer
investors would have bought into these securities,
and the losses may not have been as bad.
l Rating agencies were enticed to give better ratings
in order to continue receiving service fees, or they
run the risk of the underwriter going to a different
rating agency.
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l Investors were the ones willing to purchase CDOs at

ridiculously low premiums over Treasury bonds.

l Investors are also responsible for the whole mess

because it is up to individuals to perform due
diligence on their investments and make appropriate
expectations





l Another party that added to the mess was the hedge

fund industry.

l It aggravated the problem not only by pushing rates

lower, but also by fueling the market volatility that
caused investor losses.

l Credit Arbitrage
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