1 Credit Derivatives Southeastern Actuaries Conference Fall Meeting November 18, 2005 Credit Derivatives What are they? How are they priced? Applications in risk management Potential uses 2
2 Credit Derivatives Credit derivatives are financial contracts that allow one to synthetically take or reduce default exposure to a corporate entity. Credit derivatives are quickly becoming integrated with credit trading and risk management at many firms. The credit derivative market has grown rapidly and is an increasing portion of total debt outstanding. Notional Outstanding $B $14,000 $12,000 Cash Bonds Credit Derivatives $10,000 $8,000 $6,000 $4,000 $2,000 $0 1997 1998 1999 2000 2001 2002 2003 2004E 2007E Year Source: British Banker s Association, Bank for International Settlements 3 Credit Derivatives Credit default Swaps () make up 60% of the credit derivatives market. 15% 25% 60% Agreement between two parties to exchange the credit risk of an issuer (reference entity). No exchange of cash at time of transaction may be exchanged in future based on market outcome. Single Name Credit Index Products Other* 4
3 Credit Default Swap Buyer of pays a fee to purchase credit protection Short risk Similar credit risk position to selling a bond short Profit if reference entity has a credit event Seller of collects a periodic fee Long risk Similar credit risk to owning a bond Profit if the credit of the reference entity has no credit event Fee = notional of swap market price of (spread) Quoted in basis points Function of reference entity s credit risk 5 Credit Default Swap Settlement of No Credit Event matures, no settlement, periodic payments from buyer to seller stop. Credit Event settlement swap can be settled by physical or cash settlement. Physical Settlement buyer delivers seller bonds with face value equal to notional amount of swap. Seller pays notional amount in cash to buyer. Cash Settlement buyer and seller agree to unwind trade based on market price of defaulted bond. Notional- recovery rate. 6
4 Credit Default Swap The most common applications are replication transactions. Replication involves the purchase of an underlying bond and the sale of a credit default swap. Cash is invested in the underlying asset is attached to a host bond No upfront cash investment with Receive periodic payment Similar credit risk to owning bond Resulting yield is equivalent to holding a bond A function of underlying bond yield and premium Synthetically replicate a long bond position 7 Credit Default Swap Terminology/Mechanics market terminology can be confusing. Selling has similar credit risk to buying a bond, while buying is similar to selling a bond. No upfront cash investment with Reference Entity (credit exposure) Investor B Protection Buyer Risk (Notional) (Credit Spread) Periodic Coupons Contingent payment upon a credit event Investor S Protection Seller Buy Buy Protection Short Risk Pay Periodic Payments Sell Sell Protection (against default) Long Risk Receive Periodic Payments Credit risk profile of selling a bond Credit risk profile of owning a bond 8
5 Credit Default Swap Pricing Credit default swaps and bonds of the same credit both reflect the market s view of default risk, and should trade similarly. Bond Yield Risk Free Rate (Treasury) + Credit Risk Yield Risk Free Rate (Treasury) Swap Spread + Credit Risk Swap Rate/ Libor Compare bond spread to spread to evaluate the relative value of 9 Credit Default Swap - Pricing Bond price matters when comparing the economics of cash instrument and a. A long position in a bond and a can trade at the same spread but have a different loss profile in the case of a default. Bond Credit Default Swap Par (notional) $100 Cash at risk (notional) $100 Bond price $110 price $100 Ratio of par to price 0.9091 Default recovery price $40 Default recovery price $40 Cash loss (110-40) 0.909 Cash loss 100-40 = = $63.64 $60 Premium bonds have more risk in the case of default. 10
6 Credit Default Swap - Pricing The basis between a bond and can signal trading opportunities. Basis refers to the difference, in basis points, between a spread and a bond s par equivalent spread Negative basis: spread < bond spread Positive basis: spread > bond spread Potential Trade Negative Basis Spread Bond s Par Equivalent Spread < 0 Buy Bonds Buy Protection (long risk) (short risk) Potential Trade Positive Basis Spread Bond s Par Equivalent Spread > 0 Sell Protection Sell Bonds (long risk) (short risk) 11 Application for Risk Management Credit derivatives produce a more flexible structure for managing risk than the cash market. Means of separating the credit risk from interest rate risk Efficient mechanism for shorting a credit Synthetically trade without recognition of a capital gain (or loss) for accounting or tax purposes Remove credit risk with minimal book yield impact Provides ways to tailor credit investments Diversification of names Assume exposure to credits that don t actively trade in the market Variety of structures available 12
7 Flexibility of Instrument provides opportunities to independently manage credit risk. Remove Credit Risk Add Credit Risk 5-yr Interest Rate Remove credit risk for full term Add credit risk for full term Sell 5-yr 5-yr Interest Rate Buy Portfolio Protection 30-yr Bond Remove credit risk for portion of term Remove portfolio credit risk 5-Year Add portfolio credit risk Add credit risk for portion of term Sell 5-yr 30-yr Interest Rate Sell Portfolio Protection 30-Yr Bond Portfolio 30-yr Portfolio Interest Rate 13 Applications for Risk Management Buying protection offers alternative to selling high book yield asset and may result in higher yield/income than selling asset and reinvesting proceeds. Sell Asset and Reinvest Keep Asset and Buy Credit Protection Own Asset (BB Rating) 10-year Asset Kerr McGee (KMG) Sell Asset Reinvest at Current Interest Rates (BBB Rating) 10-year BBB Corp. Bond VS. Own Asset (BB Rating) 10-year Asset Kerr McGee (KMG) Remove Credit Risk Buy KMG 2.50% Maintain Above Market Interest Rate (AAA/AA Risk) Equivalent AAA/AA Credit Book Yield 9.50% New Book Yield 5.25% Book Yield 9.50% Cost = 2.50% Net Book Yield 7.00% 14
8 Potential Uses of Credit Derivatives Credit derivatives offer insurance companies the opportunity to increase the performance of their general account investment portfolios. Operational Leverage Alternative Selling protection has low implicit costs. Provides attractive return on capital compared to other leverage opportunities. Balance Sheet Management Synthetic trading with default swaps enables capital efficient repositioning of credit holdings without triggering gains/losses. Relative Value Opportunities On a opportunistic basis, spreads in default swaps are sometimes wider than the cash bonds for particular names. Diversification and Income Enhancement Robust liquidity and flexibility in the structured credit markets can create investment and yield profiles unavailable in the conventional cash markets. 15 Potential Uses of Credit Derivatives Leveraged Credit Exposure A First To Default Basket exchanges fixed premium payments in return for a promise to make payment on the first credit in a specified portfolio to experience a credit event. First-to-Default Basket Swap Reference Portfolio Investor A1 Rated Contingent Credit Protection Payment On First-to-Default Premium 100 bps Counterparty 36 bps Weighted Average Premium AXP (A1) 30 bps JPM (Aa3) 35 bps MER (Aa3) 35 bps GS (Aa3) 35 bps BSC (A1) 40 bps Strategic Rationale: Enables insurance companies to diversify into higher quality names where they have little or no exposure. Increased yield in the higher quality names provided by investing in leveraged credit risk. 16
9 Potential Uses of Credit Derivatives Purchase of insurance on a portfolio to provide a layer of credit protection over a specified time horizon (Credit Reinsurance). Total Portfolio Exposed to Portfolio Losses No Portfolio Loss Exposure Exposed to Portfolio Losses 17 Potential Uses of Credit Derivatives Second generation credit derivatives are creating further opportunities for risk management. Take diversified long or short exposure to specific credit market Index position Trade credit market volatility Credit default swap options Trade on expected recovery rates Recovery swap Trade on expected credit spread Constant maturity Take leveraged credit position First-to-default basket 18
10 Benefits/Limitations of POSITIVES NEGATIVES Separate credit from interest rate decision Credit spread pickup/improved earnings Liquidity more names/diversification Explanation risk greater on non-hedging derivatives not viewed like cash instruments Mark-to-market volatility for GAAP Mitigated if long & short Greater accounting scrutiny for derivatives 19