Prashanta k. Banerjee, Ph.D.

Fulbright Scholar
Professor and Director (RDC)
Kind of Risk Exposure Covered
by Derivative Contracts
Interest Rate risk
Foreign Exchange Risk
Equity Risk
Credit Risk
Commodity and Other Risk Exposures
Credit Risk
Company / Borrower Specific Risk
Market Risk
Interest Rate Risk
Currency Risk
What Cause Default
Failure to Pay
Bankruptcy
Credit Event after Merger
Govt. Action
World Economy
Derivatives
Refusing Loan
Asking Payment Before
Credit Derivatives :

Credit Default Swap ,Interest Rate Swap, Credit

Insurance , Securitization, Factoring,
Option and Forward
Bangladesh Perspective
Appraisal
Monitoring
Diversified Portfolio
Relationship
SWAP
Exchange of one thing for another

In a financial context, the exchange typically consists

of one cash flow being exchanged for another cash
flow.
What is Asset SWAP
An asset swap is an exchange of tangible assets for
intangible assets or vice versa.
Interest Rate SWAPS
Interest Rate SWAPS is a way to change a borrowing
Institutions' exposure to interest rate fluctuations
and achieve lower borrowing costs.
 5%
AAA Corp BBB Corp
LIBOR
 Fixed Interest
Floating Interest Rates
Rates Parties Potential Interest Rate
Parties must Pay if
Parties of the Swap must Pay if They Savings of Each
They Receive a Short-
Issue Long-term Borrower
term Loan
Bonds

A lower-credit rated borrower 11.50% Prime + 1.75% 0.50%

A higher-credit rated borrower 9.00 Prime interest rate 0.25

Difference in interest rates due 2.50% 1.75% 0.75%

to differences in borrowers’
credit ratings (quality spread)
A Bilateral Contract where a seller of
credit risk /protection buyer pays a
premium to the buyer of the credit
risk/protection seller for protection
related to credit event on
underlying credit obligation.
Credit Events
Bankruptcy
Failure to Pay
Restructuring in terms of an Obligation
Obligation Acceleration
 Obligation Default Repudiation/Moratorium


A Standard Credit Default Swap (CDS)
Fee (monthly, quarterly,
semiannual, annual)
Protection Protection
Buyer Seller
Payment,
Contingent on credit event
in reference asset

Reference
Asset (Bond,
loan, or other)
 Digital Credit Default Swaps

Protection Payment = Principal – Market Recovery Value Protection

Buyer Seller

Protection Protection
Payment = Principal – Fixed Recovery Value Seller
Buyer
Example of a Call Option Transaction
A financial firm plans to purchase $50 million in
Treasury bonds in a few days and hopes to earn an
interest return of 8 percent. The firm’s investment
officer fears a drop in market interest rates before she
is ready to buy, so she asks a security dealer to write a
call option on Treasury bonds at a strike price of
$95,000 for each $100,000 bond. The investment offer
had to pay the dealer a premium of $500 to write this
call option. If market interest rates fall as predicted,
the t-bonds’ market price may climb up to $97,000 per
$100,000 bond, permitting the investment officer to
demand delivery of the bonds at the cheaper price of
$95,000.
 Solution
The call option would then be “in the money” because
the securities’ market price is above the option’s
strike price of $95,000.

Before-tax profit on call option = Security market

price – Strike price – option premium
The before-tax profit on each $100,000 bond
would be:
Before-tax profit on call = $97,000 - $95,000 - $500
= $1,500 per bond
Case –on CDS
Bank B has huge exposure to steel industry say to the
tune of Tk. 2,500 cr, much beyond the stipulated norm
of the exposure limits. The bank plans to diversify into
textile industry. Another bank A would like to take
exposure to steel industry and offer protection at 55
basis points to bank B for a period of three years.

 Questions to be answered?
1. Benefit of protection seller Bank A.
2. How much will be paid by the protection seller if
any credit event is happened?
Answer of Case 1
The protection seller Bank A receives an annual
premium of Tk. 13.75 cr [Tk. 2.500 cr × 0.0055] per
year. if during the life of the credit default swap, a
credit event occurs, the protection seller will pay Tk.
2,500 cr to protection buyer. However, the physical
delivery or cash settlement would depend on the
terms of the swap agreement
Impact on Balance Sheet
 Since it is a swap of assets, the procedure takes
place on the active side of the balance sheet and has
no impact on the latter in regards to volume.

 For example, a company may sell equity and

receive the value in cash thus increasing liquidity.
Credit Insurance
Between a protection buyer and specialized insurance
company.
Protection buyer will insurance premium regularly.
Insurance co will pay the agreed amount if there is a
loss.
It is unfunded
Can be reinsured with another insurance
/reinsurance company.
 Call Option
 Kamal is a speculator who buys a British pound call option with a
strike price of $1.41 and a December settlement date from the
HSBC Bank . Just before the expiration date, the spot rate of the
British pound reaches $1.43 and the current spot price as of that
date is about $1.40. Kamal pays a premium of $0.12 per unit for the
call option. At this time, Kamal exercises the call option and then
immediately sells the pounds at the spot rate to a bank. One
option contract represents £51,250

Requirements: (i) Mention types of option (in/out/at) (ii) Compute

the profit or loss of Mr. Kamal and HSBC in this option contract.
 
(b)
Put Option
A put option contract on British pounds specifies the
following information:
Put option premium on British pound (£) = $.04 per
unit.
Strike price = $1.40.
One option contract represents £31,250.
Spot price at the time of contract = $ 1.41

Requirements: (i) State a practical situation where this

contract can be used(ii)Mention the spot price for
making this contract at the money and prove it.
Use of Asset SWAP
A company often utilizes this method when in need
for money to invest internal financing or to
pay-off debts.
Asset SWAP and Cash Flow.
In finance, the term asset swap has a particular meaning.
When one refers to an asset swap, one has in mind the
exchange of the flow of payments from a given security
(the asset) for a different set of cash flows.

An example of this is where an institution swaps the cash

flows on a U.S. Government Bond for LIBOR minus a
spread (say 20 basis points). Such swaps usually have
stub /END periods in order to bring the chronology of the
cash flows into line with that of the underlying bond.
Loan Sale
loan sale is a sale, often by a bank, under contract of
all or part of the cash stream from a specific loan,
thereby removing the loan from the bank's balance
sheet.
How Does Commonly It work?
Often subprime loans from failed banks in the United
States are sold by the Federal Deposit Insurance
Corporation (FDIC) in an online auction format .
Trader in the Loan Sale Market
The Debt Exchange, Mission Capital Advisors,
Garnet and First Financial, all of which are listed
on the FDIC's website under Asset Sales and the
Carlton Group (under Carlton Exchange).
Performing loans are also sold between financial
institutions. Mandel & Company is an example of
a leading financial services firm that arranges
performing loan sales.