Understanding Credit Derivatives and Related Instruments (Academic Press Advanced Finance)

355 Pages·2004·2.96 MB·English

by  Antulio N. Bomfim

Understanding Credit
Derivatives and Related
Instruments

Understanding Credit
Derivatives and Related
Instruments
Antulio N. Bomfim
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Contents
I Credit Derivatives: Definition, Market, Uses 1
1 Credit Derivatives: A Brief Overview . . . . . . . . . . . . 3
1.1 What are Credit Derivatives? . . . . . . . . . . . . . . . . . 3
1.2 Potential “Gains from Trade” . . . . . . . . . . . . . . . . 5
1.3 Types of Credit Derivatives . . . . . . . . . . . . . . . . . . 6
1.3.1 Single-Name Instruments . . . . . . . . . . . . . . . 6
1.3.2 Multi-Name Instruments . . . . . . . . . . . . . . . 7
1.3.3 Credit-Linked Notes . . . . . . . . . . . . . . . . . . 8
1.3.4 Sovereign vs. Other Reference Entities . . . . . . . . 8
1.4 Valuation Principles . . . . . . . . . . . . . . . . . . . . . . 9
1.4.1 Fundamental Factors . . . . . . . . . . . . . . . . . 10
1.4.2 Other Potential Risk Factors . . . . . . . . . . . . . 11
1.4.3 Static Replication vs. Modeling . . . . . . . . . . . . 12
1.4.4 A Note on Supply, Demand, and Market Frictions . 14
1.5 Counterparty Credit Risk (Again) . . . . . . . . . . . . . . 15
2 The Credit Derivatives Market . . . . . . . . . . . . . . . . 17
2.1 Evolution and Size of the Market. . . . . . . . . . . . . . . 18
2.2 Market Activity and Size by Instrument Type. . . . . . . . 19
2.2.1 Single- vs. Multi-name Instruments . . . . . . . . . 20
2.2.2 Sovereign vs. Other Reference Entities . . . . . . . . 21
viii Contents
2.2.3 Credit Quality of Reference Entities . . . . . . . . . 21
2.2.4 Maturities of Most Commonly
Negotiated Contracts . . . . . . . . . . . . . . . . . 23
2.3 Main Market Participants . . . . . . . . . . . . . . . . . . . 23
2.3.1 Buyers and Sellers of Credit Protection . . . . . . . 24
2.4 Common Market Practices . . . . . . . . . . . . . . . . . . 25
2.4.1 A First Look at Documentation Issues . . . . . . . . 26
2.4.2 Collateralization and Netting . . . . . . . . . . . . . 27
3 Main Uses of Credit Derivatives . . . . . . . . . . . . . . . 29
3.1 Credit Risk Management by Banks . . . . . . . . . . . . . 29
3.2 Managing Bank Regulatory Capital . . . . . . . . . . . . . 31
3.2.1 A Brief Digression: The 1988 Basle Accord . . . . . 31
3.2.2 Credit Derivatives and Regulatory
Capital Management . . . . . . . . . . . . . . . . . 33
3.3 Yield Enhancement, Portfolio Diversification . . . . . . . . 35
3.3.1 Leveraging Credit Exposure,
Unfunded Instruments . . . . . . . . . . . . . . . . 35
3.3.2 Synthesizing Long Positions
in Corporate Debt . . . . . . . . . . . . . . . . . . . 36
3.4 Shorting Corporate Bonds . . . . . . . . . . . . . . . . . . 37
3.5 Other Uses of Credit Derivatives . . . . . . . . . . . . . . . 38
3.5.1 Hedging Vendor-financed Deals . . . . . . . . . . . . 38
3.5.2 Hedging by Convertible Bond Investors . . . . . . . 38
3.5.3 Selling Protection as an Alternative
to Loan Origination . . . . . . . . . . . . . . . . . . 39
3.6 Credit Derivatives as Market Indicators . . . . . . . . . . . 39
II Main Types of Credit Derivatives 41
4 Floating-Rate Notes . . . . . . . . . . . . . . . . . . . . . . . 43
4.1 Not a Credit Derivative... . . . . . . . . . . . . . . . . . . . 43
4.2 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 43
4.3 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 45
4.4 Valuation Considerations . . . . . . . . . . . . . . . . . . . 45
5 Asset Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
5.1 A Borderline Credit Derivative... . . . . . . . . . . . . . . . 53
5.2 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 54
5.3 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 56
5.4 Valuation Considerations . . . . . . . . . . . . . . . . . . . 58
5.4.1 Valuing the Two Pieces of an Asset Swap . . . . . . 59
5.4.2 Comparison to Par Floaters. . . . . . . . . . . . . . 62
Contents ix
6 Credit Default Swaps . . . . . . . . . . . . . . . . . . . . . . 67
6.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 68
6.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.2.1 Protection Buyers . . . . . . . . . . . . . . . . . . . 70
6.2.2 Protection Sellers . . . . . . . . . . . . . . . . . . . 71
6.2.3 Some Additional Examples . . . . . . . . . . . . . . 72
6.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 73
6.3.1 CDS vs. Cash Spreads in Practice . . . . . . . . . . 76
6.3.2 A Closer Look at the CDS-Cash Basis . . . . . . . . 78
6.3.3 When Cash Spreads are Unavailable... . . . . . . . . 80
6.4 Variations on the Basic Structure . . . . . . . . . . . . . . 82
7 Total Return Swaps . . . . . . . . . . . . . . . . . . . . . . . 83
7.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 83
7.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 85
7.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 87
7.4 Variations on the Basic Structure . . . . . . . . . . . . . . 89
8 Spread and Bond Options . . . . . . . . . . . . . . . . . . . 91
8.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 91
8.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 93
8.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 95
8.4 Variations on Basic Structures . . . . . . . . . . . . . . . . 96
9 Basket Default Swaps . . . . . . . . . . . . . . . . . . . . . . 99
9.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 99
9.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 101
9.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 101
9.3.1 A First Look at Default Correlation . . . . . . . . . 104
9.4 Variations on the Basic Structure . . . . . . . . . . . . . . 105
10 Portfolio Default Swaps. . . . . . . . . . . . . . . . . . . . . 107
10.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 107
10.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 110
10.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 110
10.3.1 A First Look at the Loss Distribution Function . . . 111
10.3.2 Loss Distribution and Default Correlation . . . . . . 113
10.4 Variations on the Basic Structure . . . . . . . . . . . . . . 116
11 Principal-Protected Structures . . . . . . . . . . . . . . . . 117
11.1 How Does It Work? . . . . . . . . . . . . . . . . . . . . . . 117
11.2 Common Uses . . . . . . . . . . . . . . . . . . . . . . . . . 119
11.3 Valuation Considerations . . . . . . . . . . . . . . . . . . . 119
11.4 Variations on the Basic Structure . . . . . . . . . . . . . . 122