An Introduction to Credit Derivatives

164 Pages·2013·5.75 MB·English

by  Moorad Choudhry (Auth.)

AN INTRODUCTION TO
CREDIT DERIVATIVES
SECOND EDITION
People still crave explanations even when there is no underlying under-
standingaboutwhat’sgoingon...erraticstockmarketmovementsalways
find areadyexplanation inthenext day’sfinancialcolumns:aprice rise
is attributed to sentiment that ‘pessimism about interest rate increases
was exaggerated,’ or to the view that ‘company X had been oversold.’
Ofcoursetheseexplanationsarealwaysaposteriori:commentatorscould
offeranequallyreadyexplanationifastockhadmovedtheotherway.
ProfessorMartin Rees
Our CosmicHabitat
London: Phoenix(2003),page 101
AN
INTRODUCTION
TO CREDIT
DERIVATIVES
SECOND EDITION
Moorad Choudhry
AMSTERDAM(cid:129)BOSTON(cid:129)HEIDELBERG(cid:129)LONDON
NEWYORK(cid:129)OXFORD(cid:129)PARIS(cid:129)SANDIEGO
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Dedication
Dedicated to mywife,Lindsay Choudhry
The streetof shame isa streetof hacks
The menbehindthe men who do dealsbehind our backs
The fourth estate isa houseof hate
Media pimps with scant regards for facts
They nail their victims with a telephoto to the ground
Feed the peopleon scraps of evil
And their dailydiet (cid:1)a platefulof hateful.
Private greed,notpublicneed
Life’sgeared to profit, money,wealth
They can’t get enough of it.
And inthe papers thesame oldstory
Every picture sellsa Tory
Money, profit, wealth,
They can’t get enough of it,
Money, profit, wealth
Can’t get enough ofit....
—Redskins, APlatefulof Hateful(King/Dean/Hewes)
from NeitherWashington nor Moscow, LondonRecords 1986
Reproducedwithpermission.
About the Author
Moorad Choudhry is Head of Treasury, Corporate Banking
Division, at The Royal Bank of Scotland. He is Visiting Professor at the
Department of Mathematical Sciences, Brunel University, and Visiting
Teaching Fellow at the Department of Management, Birkbeck,
University of London.
Moorad is a Fellow of the Chartered Institute for Securities &
Investment and a Fellow ofthe ifs-SchoolofFinance. Heisonthe Editorial
Board of the Journal of Structured Finance and American Securitization, and
isamemberoftheBoardofDirectorsofPRMIA.
xi
Foreword
We are witnessing one of the most important episodes in financial
history. The situation started with the crisis in the US financial system,
is now challenging the European Union project and will hopefully fin-
ish with some lessons learned and a more robust and efficient financial
system.
Arguably, the start of this crisis goes further back in time with years
of excess leverage in the private sector ignited by low interest rates and
prodigious financial innovations. The failure by some agents to identify
the risks associated with such leverage and the interconnectivity of a
global financial community has resulted in the difficult economic envi-
ronment we are now experiencing. Governments had to step in and
assume the excesses of the private sector to contain the effects of a dis-
ordered asset reduction. The challenge is now of course the delever-
aging of thepublic sector itself.
At the heart of this financial innovation were credit derivatives.
Traditionally the concept of credit was intimately linked to funding.
One could not get exposure to a company without lending to it either
through a bond or a loan. The introduction of credit derivatives was
particularly important as it enabled the transfer of credit risk without
funding or arelationship with theissuerof the underlying credit.
A new world of possibilities was immediately created. Financial
intermediaries could shape the risks of their portfolios through credit
default swaps (CDS), buying and selling credit protection. Investors
could have access to synthetically created customized products that ful-
filled their requirements at virtually anytime.
Credit worthiness was now truly an asset class of its own and credit
derivatives expanded its applications as they transferred credit risk to
counterparty risk. For lenders it is not only important to buy protection
to offset the threat of default by a borrower, but it is equally important
to assess the credit quality of the counterparty from whom the protec-
tionisbought,as well as thecollateral terms. For instance,theexamples
of AIG and Lehman have demonstrated the importance of introducing
counterparty value adjustments (CVA).
Much has been written about the role of credit derivatives in the
development of the actual economic situation. In fact, a great part of
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xiv
FOREWORD
what has been written condemns credit derivatives. But as with many
other innovations in history, it is the usage and not the tool that creates
theproblems.
As over-the-counter (OTC) instruments, credit derivatives practi-
tioners have been involved through different industry bodies, mainly
theInternationalSwapsandDerivativesAssociation(ISDA),instrength-
eningthedocumentationandmakingtheliquidationprocessofdefaults
transparent, responding to challenges as they arose. This has been a
good start and sets solid ground, but is not enough. Challenges remain
tobeaddressed,suchtheconcentrationoftheindustrywithinahandful
of counterparties, and the migration to central clearing counterparties
(CCPs)tomitigatecounterpartyrisk.
Policy makers have been busy preparing new regulations with the
aim of implementing them as soon as possible hoping to avoid the mis-
takes of the past. Dodd-Frank, the Volcker Rule, BIS3 and CRD4,
MiFID, Sovency II, among others, contain very plausible measures for
financial institutions and insurers, but as the drafting of these rules is
evolving a clear and timely implementation would be desirable to have
arobust regulatory framework in thefuture.
It is therefore important to understand the credit product and have
all the relevant information to be able to diligently get involved with
credit derivatives. In this valuable book you will be able to learn about
thetheory,insights,usages andimplications ofcreditderivatives.
Finally, we have now the possibility of reflecting on previous finan-
cial crises to understand how they eventually came to an end, and we
have a unique opportunity to make sure that new such episodes are not
repeated. Better information and a responsible application of financial
innovation should guarantee an efficient flow of capital to help the
development of prosperous andsustainablegrowth.
Juan Blasco
Head ofCreditProducts
WholesaleBankingand Marketing
Lloyds Bank Group
19October 2012
Preface
Finance is a dry, unemotional subject. At least, it should be.
Discussing any aspect of it should not be a cause for undue stress or
argument. It isn’t as if one is debating abortion rights or the
Arab(cid:1)Israeli peace process when one enters into a conversation on
financial products. Any discourse in this field should be logical and
objective, aimed at arriving at a sound solution that meets the needs of
therelevant stakeholders.
Sadly, in the era following the banking crash of 2008, when the US
and a number of European governments had to spend a considerable
sum of taxpayers’ money saving their banking sector, we encounter
considerablesubjective andemotionaldebateinfinance.Somecommen-
tators have suggested that ‘CDOs’ caused the financial crash. Others,
including some so-called ‘gurus’ best known for specific trades they
may have undertaken over 20 years ago or who worked in banking
over 30 years ago, have suggested that credit default swaps (CDS)
caused thecrash and should bebanned to prevent the next crash.
This is utter nonsense. Financial instruments didn’t cause the crash
any more than tulips caused the crash of 1637 or Gordon Gekko caused
the crash of 1987. A number of factors, working in concert, combined to
produce a market correction and what all crashes have in common is
speculation, mis-pricing, greed, applying incorrect or inaccurate
assumptions and an inept understanding of the basic principles of
finance. For tulips we can substitute sub-prime mortgages, for example,
but on its own a financial instrument does not cause a crash. If used in
a certain way certain products may make it easier for the effects of mis-
pricing to be transferred more quickly across the market, but of itself it
is financially illiterate to suggest that CDOs or CDS caused the crash.
To do so only reflects subjective andemotional thinking.
This book isn’t about the crash of 2008 or indeed any other crash.
Rather, it is an introduction to a particular type of bank risk manage-
ment product known as the credit derivative. The emergence of this
product in the financial markets in the mid-1990s resulted in a repeat of
the classic ‘tail wagging the dog’ scenario that one had observed in the
1980s, when interest-rate derivatives were introduced. Now the princi-
pal instrument used for valuation and analysis of the credit asset class
xv