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Sydney RPC Level 14, 2 Park Street Sydney NSW 2000 Australia
Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
Credit Derivatives
Separation of credit risk from funding / liquidity risk Creation of array of unfunded credit products
Leading to
increased credit risk trading opportunities increased investor access to credit products
Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
Definition:
CDS are credit derivatives in which Protection buyer pays periodic fee
to Protection seller and Seller covers Buyer against default
CDS transfers the potential loss on an reference asset that can result
from specified credit events such as bankruptcy, default etc
Correlation
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CDS Payoffs
Protection Buyer
Protection Seller
Protection Buyer
Deliverable Obligations of the Reference Entity
Protection Seller
Protection Buyer
Protection Seller
to Seller
Illegality and Impossibility of Physical Delivery View on the potential price of relevant assets of the defaulted entity after a
certain time period
Liquidity of the underlying security Protection buyer may have access to Cheapest-to-Deliver bond
Key Features:
CDS Applications
Buyer Applications:
Synthetically short security Hedge credit on held asset Diversify concentrated portfolio
Seller Applications:
Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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Definition:
The buyer pays a periodic fee to seller and receives total economic
performance of underlying reference asset in return
So if price goes up, buyer gets and amount = appreciation in value If price goes down, buyer pays an amount = decline in value
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TRS Payoffs
Payoff:
Receiver earns coupons + periodic positive MTMs on reference asset Receiver pays Libor + Margin + periodic negative MTMs on reference
asset
Transfers total performance without transfer of asset Captures spread movement and default Unfunded equivalent of funded asset purchase
Total positive returns on Ford Bond Receiver LIBOR + Margin + Losses on Reference Bond Payer
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TRS Features
Applications:
Self-financing; create leverage Lock in funding rate Access to new markets/securities with no repo market
Pricing:
Cost of funds and capital Repo cost of reference asset Counterparty risk Correlation
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Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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CLN/CLD are, unlike CDS, funded instruments which allows the credit
protection buyer to avoid the contingent credit exposure to the protection seller.
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On Trade date:
Note Issuer
Investor
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For Investors:
New credit risks Credit risk in new currencies Credit risk for unavailable maturities
CLNs provide yield leverage (more than one name exposure) CLNs provide the portfolio effects of diversification However, these are complex to execute and have less liquidity vs.
Eurobonds)
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For Issuers:
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Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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Option seller gives right to buyer to buy/sell asset at agreed spread over Libor E.g., A put option on credit spreads gives the buyer the right but not the
obligation to sell the underlying asset/purchase credit default protection at a certain pre-specified credit spread
This effectively gives the buyer of a credit spread put option protection against
credit spreads widening at a future date
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E.g.:
Bank C owns asset XYZ at L+20 bp but needs credit line Bank D will buy asset at L+25 bp Bank C buys 1 year put struck at L+25 bp for 10 bps Bank C replaces XYZ risk with Bank D risk Bank D takes contingent credit risk on XYZ
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E.g.:
premium 10 bp
Bank C
Bank D
L + 20 bp if spread > 25 bp
XYZ bond
if spread < 25 bp
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Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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Portfolio Products
FIRST-TO-DEFAULT BASKETS:
A credit default swap in which swap returns are linked to first default in a
basket of issuer.
The exposure to each name is for full notional of the protection and principal
and interest are at risk only to the Reference Entity being the first to default.
Cheaper than buying single name default swaps for each name in the basket
Buying 2nd and 3rd etc. to default increases extent of credit protection Spread of worst credit < basket swap spread < Sum of spreads of individual
credits
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Principal Amount: USD 10 mio Maturity: 5 years Interest: Libor + 270 bps p.a. (semi-annually) Reference Basket:
Note Issuer
Investor
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Note Issuer
Investor
Note Issuer
Investor
No payments after Credit Event
Investor
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Hybrid Products
A structured credit default swap where the notional is denominated in a nonstandard (non-G7) currency
A swap that will be terminated with zero termination value upon the occurrence
of a credit event on the swap counterparty and/or a third-party reference credit.
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Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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Documentation:
Conditions of Payment:
Bankruptcy Cross Acceleration / Cross Default Failure to pay (on what / how much?) Restructuring Repudiation Credit Spreads widening etc
Publicly Available Information like Reuters / Telerate etc
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Table Of Contents
Credit Derivatives Introduction Credit Default Swaps Total Return Swaps Credit Linked Note/Deposits Credit Spread Options Portfolio and Hybrid Products
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MTM: Mark to Market CDS: Credit Default Swap BP: Basis Point TRS: Total Return Swap CLN: Credit Linked Note CLD: Credit Linked Deposit Mio: Million
MM: Million
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