Copyright SDA Bocconi, protocollo xxxx
Lecture 9: Credit Derivatives
Derivatives in Corporate Finance
Alonso Peña
SDA Bocconi, Intermediazione Finanziaria e Assicurazioni
Copyright SDA Bocconi, protocollo xxxx 2 2
Part 1: Introduction Part 2: Credit Derivatives: a Guided Tour Part 3: CDS Part 4: Examples
Contents
Copyright SDA Bocconi, protocollo xxxx
Hammurabi Code (1792 to 1750 BC)
First regulations of
interest, forgiveness of debt and extension of
credit
Payments through a local banker or by
written draft against deposit
Copyright SDA Bocconi, protocollo xxxx
Interest was rarely charged on advances by the temple or wealthy landowners for pressing needs. Merchants (and even temples, in some cases) made ordinary business loans, charging from 20 percent, for loans on silver, and 33.3 percent, for loans on grain.
Copyright SDA Bocconi, protocollo xxxx 6 6
Hammurabi's code also stated: “If any one owes a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for this year.”
Copyright SDA Bocconi, protocollo xxxx 7 7
Hammurabi's code also stated: “If any one fails to meet a claim for debt, and sell himself, his wife, his son, and daughter for money or gives them away to forced labor: they shall work for three years in the house of the man who bought them and in the fourth year they shall be set free.”
Copyright SDA Bocconi, protocollo xxxx 8 8
Credit, noun, the facility of being able to obtain goods or services before payment, based on the trust that payment will be made in the future. From the latin creditum, from credere, to believe.
Oxford English Dictionary (2007)
Introduction The word “credit”
Copyright SDA Bocconi, protocollo xxxx 9 9
Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both)
Introduction Credit Risk
Copyright SDA Bocconi, protocollo xxxx 10 10
Credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.
Introduction Credit Derivatives
Copyright SDA Bocconi, protocollo xxxx
A
B
INTEREST RATE derivative
client bank
Interest rate
A
B
CREDIT derivative
client bank
Credit
Copyright SDA Bocconi, protocollo xxxx 13 13
Credit default swap (CDS) Total return swap (TRS) Constant maturity credit default swap (CMCDS) First to Default Credit Default Swap (F2D) Credit Spread Option (CSO) CDS index products (iTraxx, CDX) Credit linked note (CLN) Collateralized Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO) Constant Proportion Portfolio Insurance (CPPI)
Introduction Types of Credit Derivatives
Copyright SDA Bocconi, protocollo xxxx 14 14
Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity. The parties will select which credit events apply to a transaction and these usually consist of one or more of the following: • bankruptcy • failure to pay • repudiation • moratorium • restructuring
Introduction Credit Events
Copyright SDA Bocconi, protocollo xxxx 16 16
Introduction The most popular credit derivative…
credit default swap (CDS)
debt linked sensitive to default
exchange cashflows
Copyright SDA Bocconi, protocollo xxxx 22 22
Structural Models
Intensity Models
Guided Tour
credit risk
modeling
Credit Scoring Models
Copyright SDA Bocconi, protocollo xxxx 28 28
Merton, Robert C., "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates", Journal of Finance, Vol. 29, No. 2, (May 1974), pp. 449-470.
Merton (1974) Structural Model
t t tdV V dt V dW
evolution of the firm
growth component
random component
Copyright SDA Bocconi, protocollo xxxx 35 35
Robert A. Jarrow and Stuart Turnbull, "Pricing Derivatives on Financial Securities Subject to Credit Risk" Journal of Finance, vol. 50, March, 1995
Jarrow-Turnbull (1995) Intensity Models
survival probability
hazard rate (flat)
maturity
(0, ) expP T T
Copyright SDA Bocconi, protocollo xxxx 36 36
Jarrow-Turnbull (1995) Intensity Models
0(0, ) exp ( )
T
P T s ds
survival probability
hazard rate (term-structure)
Robert A. Jarrow and Stuart Turnbull, "Pricing Derivatives on Financial Securities Subject to Credit Risk" Journal of Finance, vol. 50, March, 1995
Copyright SDA Bocconi, protocollo xxxx
A
B client bank
C
Premium Leg
Default Leg
reference entity (bond)
Credit Default Swap
Copyright SDA Bocconi, protocollo xxxx
A
B client bank
C
reference entity (bond)
Premium Leg
Default Leg
Credit Default Swap
Copyright SDA Bocconi, protocollo xxxx 42 42
C
reference entity (bond)
NO DEFAULT
DEFAULT
Credit Default Swap
Copyright SDA Bocconi, protocollo xxxx
A
B
bank
client
time
pa
y
NO DEFAULT Credit Default Swap
Premium Leg
Default Leg
Copyright SDA Bocconi, protocollo xxxx
A
B
bank
client
time
pa
y
Premium Leg
Default Leg
DEFAULT Credit Default Swap
Default