Derivatives are financial instruments that can efficiently transfer some form of risk from one party to another. It can be classified based on the form of risk that is being transferred like interest rate risk for interest rate derivatives, credit risk for credit derivatives, currency risk for foreign exchange derivatives, commodity price risk for commodity derivatives, and equity prices for equity derivatives.
Credit derivatives are bilateral contracts that transfer credit default risk from one counterparty to another. Credit derivatives separates and isolates the element of credit risk from other risks, such as market and operational risks. However, credit derivatives are different from other forms of credit protection, such as guarantees and mortgage indemnity insurance due to:
- The borrower is generally asked for a mortgage indemnity policy or a guarantee
- The borrower is not aware of the transaction that is taking place as the lending bank is requesting the credit derivative
- While other forms of protection are generally not tradable, credit derivative is
A credit derivative is a financial agreement intended explicitly to shift credit risk between the transacting parties. Its value is derived from the credit performance of one or more corporations, sovereign entities, or debt obligations. Similar products have been around for centuries and include letters of credit, government export credit and mortgage guarantees, private sector bond reinsurance and spread locks. Credit derivatives differ from their predecessors because they are traded separately from the underlying assets, earlier products were contracts between an issuer and a guarantor. Credit derivatives are an ideal tool for lenders who want to reduce their exposure to a particular borrower but find it difficult to come to terms with the outright selling of the claims on that borrower.
Credit derivatives were created mainly in response to demand by financial institutions, mostly consisting of commercial banks and securities firms, for being able to hedge and diversify the credit default risks similar to those already used for transfer of risk on interest rate. Credit derivatives provide a low-cost option for investors to assume credit exposure. This has led to a growth, increase in size and the liquidity of the credit derivatives market. The other main players are the non-financial corporations, insurance/reinsurance companies, pension funds and the hedge funds. Now this risk that has been considered for long as illiquid is gradually transforming into a tradable instrument that can bring in liquidity from being written off as unsuitable for trade. The result has been that credit risk has gradually changed from an illiquid risk that was not considered suitable for trading to a risk that can be traded much the same as others.
The parties to the original transaction are called the lender and the borrower. Once the loan or the underlying asset is converted into a derivative instrument the borrower is called the ‘reference entity' and may be a corporate, a sovereign or any other form of legal entity which has incurred debt. The credit asset can be a loan, debt or any other financial asset which is transacted.
The underlying risk in the original transaction is the occurrence of a credit event. This credit event can be due to the following:
- Bankruptcy of the reference entity
- There could be an obligation default where the reference entity can default any of the obligations as per the contract.
- Obligation acceleration due to a change in certain policies due to which the reference entity will default the payment.
- The reference entity's failure to pay
- There could be a restructuring of the loan due to which certain obligations may not be met.
- Repudiation or moratorium as the government could declare it for a particular type of lending or lending to a sector.
The party trying to transfer credit risk is called protection buyer, and the counterparty trying to obtain credit risk is called protection seller. Now the market has grown and trading has become rampant. These trades now act as proxy for the trades in actual loans or bonds of the reference entity.
Credit derivatives are essentially separated into two classes the funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments of premium and any other final settlement under the contract without recourse to other assets. Here there is no upfront payment made but a periodic payment is made by the protection buyer. A funded credit derivative involves the protection seller which in most cases is a special purpose vehicle; here there is an initial payment that is made which is to be used to settle any potential credit events so the protection buyer is not exposed to the risk of the protection seller. Here the amount maybe the entire notional value of the contract. The protection buyer then issues a note or a bond with the distinction that from the amount due for repayment, the protection buyer may deduct the amount of payments, if any, required on account of credit events.
When a credit event takes place, there are two methods of settlement, called cash settlement and physical settlement. In case of default the compensation is either physical or cash. Physical settlement is when the buyer delivers the debt with face value equal to the notional amount specified in the CDS. Cash settlement is when an auction of the defaulted bonds takes place to calculate the post default market value and then the difference is compensated.
Types Of Credit Risks
In any portfolio of assets or loans the main types of risks we are exposed to especially when one takes a single position are the credit default risk and the credit spread risk.
Credit Default Risk
Default risk arises when one party fulfills his obligation and the other party is unable to fulfill their part of the obligation. If one party is unable to service their loan for three months or more, may not have reached the stage of bankruptcy and this is also called as technical default. When an issuer of debt defaults, a lender generally incurs a loss equal to the amount owed by the obligor less any amount that can be recovered from that firm as a result of liquidation, foreclosure or restructuring of the loan of the defaulted obligor.
Credit Spread Risk
The spread risk is the difference between the yields on duration matched credit sensitive bond and treasury bonds. It is the spread between the rates for risky bonds and the rates for a default risk free bonds as they may vary after the purchase.
Measurement Of Credit Risk
For the measurement of credit risk we take the help of certain models to generate the credit spread, credit rating and credits score to measure the credit risk. These models take the observable inputs in the market like the fundamentals of the economy and the firm as an input. There are three models used to measure the credit risk. These three methods are:
1. Structural Model
2. Empirical Model
3. Reduced Model
Most of the models measuring the credit risk are based on two fundamental concepts. These concepts are:
1. Default probability
2. Recovery rate.
Default probability is the probability that the counterparty will default on its obligations. Default probability can be estimated for the entire life of the organization or for some specific period such as a year or a month also called as periodic or annual default probability. Estimating the default probability of the counterparty can be done in several ways, but the most popular way is to use the following data:
- The credit background of the counterparty
- The credit rating with credit rating agencies
- An evaluation of its financial statements
- Counterparty's business - such as industry, competition, competitors, production cycle, marketing plan, business drivers etc.
- Its flexibility to adapt to sudden changes in business environment
The recovery rate is a measurement of the extent to which the market value of an obligation may be recovered if the counterparty defaults. The recovery rate, during the liquidation process, depends upon the relative seniority of debt.
Combining the default probability and recovery rate with the credit exposure of a given debt, the companies can estimate the expected loss of any given obligation using the following formula:
Expected Loss = Default Probability X Credit Exposure X ( 1 - Recovery Rate)
Managing The Credit Risk
Several techniques and tools for handling the credit risk have been developed over the years. The simplest way to avoid the credit risk is to reject the original loan application. Although, this may be a certain fool-proof method of credit enhancement, it completely eliminates the prospect of making any kind of a profit. Now just to make certain amount of profit even in the midst of all the credit risks that exist in the market, individuals, banks, companies still want to lend the money. Credit enhancement techniques, which help to reduce the credit risk of an obligation, play a critical role in encouraging the loans and investments in debts.
Types Of Credit Derivatives
The major types of credit derivatives are:
1. Credit default swaps
2. Total rate of return swaps
3. Credit linked notes
4. Credit-spread put options
Credit Default Swaps
Credit default swaps transfer the potential loss on an asset that can result from specific credit events such as default, bankruptcy, insolvency, and credit-rating downgrades. Marketable bonds are the most popular form of asset because of their price transparency.
Default swaps involve a “protection buyer” who pays a periodic or upfront fee to a “protection seller” in exchange of a contingent payment if there is a credit event. Some default swaps are based on a basket of assets and pay out on a first-to-default basis, whereby the contract terminates and pays out if any of the assets in the basket are in default. Default swaps are the largest component of the global credit derivative market with more than 85% of the market share.
Total Rate Of Return Swaps
Total rate of return swaps transfer the return and risks on an underlying reference asset from one party to another. It involves a total return buyer, who pays a periodic fee to a total return seller and receives the total economic performance of the underlying asset in return. Total return includes all interest payments on the asset plus an amount based on the change in the asset's market value. If the price goes up, the total return buyer gets an amount equal to the appreciation of the value, and if the prices decline, the buyer pays an amount equal to the depreciation in value. If a credit event occurs prior to maturity, the total rate of return swap usually terminates, and the price settlement is made immediately.
Credit Spread Put Option
These are the default swaps that stipulate credit spread widening as an event. These contracts capture the devaluations in a reference asset.
The spread is usually calculated as the yield differential between the reference bonds and interest rate swap of the same maturity. Unlike default or total rate of return swaps, counterparties do not have to define the specific credit events - the payout occurs regardless of the reasons for the credit spread movement. Credit spread put options usually involve the put buyer paying an upfront fee to a put seller in exchange for a contingent payment if the spread widens beyond a pre-agreed threshold level. Credit spread derivatives can be difficult to hedge and very complicated to model and price.
Credit Linked Notes
Credit linked notes is a type of funded credit derivative. These are securities that effectively embed default swaps within a traditional fixed income structure. In return for a principal payment when the contract is made, they typically pay periodic interest plus, at maturity, the principal minus a contingent payment on the embedded default swap.
Market Participants In Credit Derivatives Market
On the Protection Buyer's side, banks, especially the investor banks, remain the largest player with a relative share of almost half the buying market. But this relative share is getting reduced year on year, due to increasing share of the hedge funds. The securities firms follow the Banks, then the hedge funds, corporations, insurance/reinsurance firms, mutual funds, pension funds and then the government.
On the Protection Seller's side the banks still plays the largest role with almost half of the market share of transactions in selling. This is again followed by the securities firms, the hedge funds, corporations, insurance/reinsurance firms, mutual funds, pension funds and the government.
From the past data, it is quite observable that smaller credit derivatives players like securities firms, corporate, mutual funds, pension funds and even governments have increased their activity. As more participants enter in, the liquidity of the trading increases and more products are made available, which in turn might attract even more participants, thus continuing to the growth of the market.
Among the credit derivatives, credit default swap is the most popular one with a share of more than half of all the credit derivatives available in the market.
Pricing Of Credit Derivative Instruments - Credit Default Swaps
Today, there exists a market for Credit Swaps, and due to the availability of markets, the valuation of the credit derivatives can be directly derived from dealer bids, offers and market prices. To price a financial instrument like credit derivative, which transfers the credit risk, modeling of the underlying risks on the instruments is required. In a credit linked product, the risk lies in either the potential default of the reference entity or the widening of the credit spread due to the changes in the credit rating or the external environment. For example, in the case of a zero coupon bond with one year to maturity, the possible outcomes are: 1) The bond redeems at par; or 2) The bond defaults, paying some recovery value, RV.
PD → Probability of default
So, if the probability of default and the recovery value is known for a credit derivative (except credit spread put option), it is possible to compute the value of the derivative in the market.
Based on this assumption as has been followed in the Fixed Income Market, the pricing of the CDS has been computed below -:
Probability of default can be calculated from the price and recovery value of the risky cash flow from the market prices of the risky cash flow. For example, in the case of a one year risky zero coupon bond which trades at 92.46, and the risk free rate is 5%. This represents a multiplicative spread of 3% over the risk free rate, since:
If the bond had a recovery value of zero, from the pricing equation, we can see that:
And so: PD=1-11.03
Therefore, the probability of default on the bond is 2.91%.So, under the zero recovery assumption there is a direct link between the spread on the bond and the probability of default. In case there is non-zero recovery, there is a strong link between the spread and the default probability shown by the below equation:
This equation helps to calculate the probability of default on an asset given its spread over the risk free rate. Like swap rates, CDS spreads have the advantage that quotes are available at evenly spaced maturities, only the recovery rate remains the unknown and has to be estimated based on experience and market knowledge. So, in order to convert market CDS spreads into default probabilities, the first step is to strip out the effect of recovery. A standard credit default swap will pay out par value minus recovery value on the occurrence of a default event. This means that the protection seller is risking only the amount equivalent to 100% less recovery. So to compute the price that needs to be paid to an investor who is assuming 100 % risk can be computed by taking the following approximation:
Here the resulting zero recovery CDS spread is treated as a credit spread as an approximation, and therefore;
Substituting the value of S RVwe get
Benefits Of Credit Derivatives
Credit derivatives emerged as a solution to few of the problems that the banks were facing. The operation of lending was handicapped by the fact that hedging was not allowed. Once the bank lent the loan to borrowers based on the credit rating maintained by them. If the credit offered deteriorates in quality due to certain events post the lending, then the lender cannot do much to protect itself against the new piece of information that it has received. They can resort only to asking for more collateral, which may not be very effective as the market value of such assets may have dropped. They could also resort to selling of such loans to other institutions but this requires the permission of the borrower, and this can affect the relationship between the bank and the customer.
Then there is the diversification of the credit risk. Many economists for long have supported the benefits of the portfolio approach to loans through diversification. But in reality diversification is difficult to achieve due to the non-availability of the instruments which poses as an obstacle in reducing the credit risk to major clients. At this point the only option for banks was to concentrate on their own organic as well as inorganic growth. They had to resort to acquisition of other banks to expand their portfolio and thereby reduce their exposure to certain sectors.
One of the glaring solutions to the above problems was the introduction of credit derivatives. By allowing banks to take a short credit position, credit derivatives enable banks to evade their exposure to credit losses. A major benefit is that, in contrast to loan sales, credit derivatives do not require consent of the reference entity. This gives a solution to the second problem too. By hedging selectively, a bank can decrease its exposure to certain entities, thereby attaining its diversification objective without straining the client relationship.
Another advantage to the protection buyer is the ability to act on a pessimistic credit view. If an investor believes that the market is overly positive about a reference entity's scenario, for example, the investor can buy protection now in anticipation of worsening. If the investor's view turns out to be correct, the investor can end the transaction at a profit by selling protection on the entity. Such speculative activity has the advantage of adding liquidity to the market and of increasing the quality of price discovery. The ability to sell protection also allows market participants to act when it is expected that a reference entity's credit quality will improve. So here, the investor can sell protection now in the hope of selling it later by purchasing it at a lower price.
For the sellers of protection credit derivatives enable market participants to attain exposure in the form of a long credit position. A financial institution seeking to diversify its credit exposure might sell CDS protection as an alternative to making loans or buying bonds. This alternative is especially helpful to institutions that seek credit exposure but lack the legal infrastructure for lending. It is also helpful to banks seeking to diversify their loan portfolios but lacking direct relationships with desired credits.
Another benefit of credit derivatives is that they add transparency to credit markets by helping in the price discovery of credit risk as lenders and borrowers are able to compare the pricing of bonds and loans with credit derivatives. Also, the economic stability stands to benefit from the ability to transfer credit risk by buying and selling protection. Like other derivatives, this reduces the cost of risk transfer and the risk is dispersed more widely. The result is that economic shocks should have less impact than was the case prior to the existence of derivatives.
The Costs Of Credit Derivatives
The one flip side of the credit derivatives which do the risk transfer is that, instead of helping the market in price discovery and stabilization, it ends up potentially destabilizing the market because it transfers the risk from the participants that specialize in credit risk like the banks to those with less experience in managing credit risk like the insurers and hedge funds. In addition, there is the danger that anything used to disperse risk can also be used by investors seeking yield enhancement to concentrate risk, like the situation that lead to the global financial crisis of 2008. Finally, these institutions generally fall outside the regulatory reach of agencies that oversee the credit markets.
Another commonly cited cost of credit derivatives is that they reduce incentives for lenders to analyze and monitor credit quality because they now have the ability to off-load credit risk. The result is a decrease in overall credit quality. Yet another drawback would be lenders' possessing inside information about credit quality, on which they could act by buying underpriced protection.
Another potential cost of credit derivatives is that risk reduction at the individual entity level can mean higher risk at the system level. This is because, when market participants are able to hedge certain risks, they are able to increase the amount of risks they take overall.
Credit Derivatives In India
Reserve Bank of India decided on 19th June 2008, to keep in hold the issuance of the final guidelines on introduction of credit derivatives in India. The decision has been taken so as to be able to learn from the experience of the financial sector of some of the developed countries, particularly during the recessionary period. Reserve Bank of India had issued the ‘Draft Guidelines for Introduction of Credit Derivatives in India', on March 26, 2003, inviting comments from banks and other stake holders. However, taking into account the condition of the risk management practices then prevailing in the banking system, the issuance of final guidelines had been postponed. Later, it was announced in the Annual Policy Statement for 2007-08 that as a part of the gradual process of financial sector liberalization in India, it was considered appropriate to introduce credit derivatives in a calibrated manner. Modified draft guidelines on Credit Default Swaps were issued on May 16, 2007. Based on the feedback received on draft guidelines, these were revised and a second draft of the guidelines was issued, on October 17, 2007, for another round of discussion.
Need And Scope For Credit Derivatives In India
One of the more successful products introduced in India in the recent past has been the Interest Rate Derivative product. Currently, there has been a raise in the use of this product with a number of hedging benchmarks and the entry of a vast number of market players. The success of this product is due to the fact that it has helped the market to pass on the interest rate risk from one participant to another. This transmission of the interest rate risk allows for the risk to be hedged away by the risk averse players and inhabit in players who are risk takers and /or those who are able to bear the risk.
Similarly, credit risk also requires an effective transmission mechanism. It is now very important that a mechanism be developed that will allow for an efficient and cost effective transmission of credit risk amongst market participants. The current structural design of the financial market is either characterized by unevenness in credit risk with the banks and development financial institutions (DFIs) or lack of access to credit market by mutual funds, insurance companies, etc.
The major hedging device now available with banks and DFIs to hedge credit risk is to sell the loan asset or the debentures it holds. Banks and Development Financial Institutions need a mechanism that would allow them to provide long term financing without taking the credit risk if they desire so. They could also like to assume credit risk in certain sectors. On the other side, investors, including banks and DFIs, would be looking for additional yields by taking credit risks.
Nature Of Participants In The Indian Market
In order to ensure that the credit market functions efficiently, it is important to maximize the number of participants in the market to encompass banks, financial institutions, NBFCs, mutual funds, insurance companies and corporate.
Banks would be both buyers and sellers of credit risk in the market. Buying and selling of participation in the priority sector is one example where credit derivatives, although in a different form, has been practiced for several years. Financial Institutions and NBFCs can also find themselves in a similar position to the banks and are likely to be both buyers and sellers in the market.
Companies may participate in the credit derivatives market to either buy or sell protection. One instance where a company would wish to buy protection is when it is exposed to one or more buyers in a big way. On the other hand, parent companies sometimes provide guarantees to banks on behalf of subsidiaries and these could easily be structured as credit derivatives.
The use of credit derivatives by the banks and investors has grown exponentially since the commencement of this decade. Deal volumes have picked up from the occasional tens of millions of dollars to normal weekly volumes measured in hundreds of millions, if not billions, of dollars. Banks are still the most active participants, but the end-user base is expanding rapidly to include a broad range of brokers, hedge funds, institutional investors, mutual funds, money managers, insurers, and reinsurers, as well as corporates. Growth in participation and market volume is likely to continue at its current rapid pace, based on the explicit contribution credit derivatives are making to efficient risk management, better credit pricing, and liquidity. Credit derivatives can offer both the buyer and seller of risk considerable advantages over traditional alternatives. Credit derivatives represent an important innovation for global financial markets with the potential to transform the way that credit risk is originated, circulated, calculated, and managed.
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