Credit Derivatives and Structured Credit Trading, Revised Edition E-Book

Vinod Kothari

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 1016

Veröffentlichungsjahr: 2011

Beschreibung

Credit derivatives as a financial tool has been growing exponentially from almost nothing more than seven years ago to approximately US$5 trillion deals completed by end of 2005. This indicates the growing importance of credit derivatives in the financial sector and how widely it is being used these days by banks globally. It is also being increasingly used as a device of synthetic securitisation. This significant market trend underscores the need for a book of such a nature. Kothari, an undisputed expert in credit derivatives, explains the subject matter using easy-to-understand terms, presents it in a logical structure, demystifies the technical jargons and blends them into a cohesive whole. This revised book will also include the following: - New credit derivative definitions - New features of the synthetic CDO market - Case studies of leading transactions of synethetic securitisations - Basle II rules - The Consultative Paper 3 has significantly revised the rules, particularly on synthetic CDOs - Additional inputs on legal issues - New clarifications on accounting for credit derivatives/credit linked notes

Leseprobe

Copyright © 2009 Vinod Kothari

Published under license in 2009 by John Wiley & Sons (Asia) Pte. Ltd.

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Library of Congress Cataloging-in-Publication Data

ISBN: 978-0-470-82292-0

Dedicated toVishes, my son

Table of Contents

Foreword

Preface

Part 1: Market, instruments, and motivations

Chapter 1: Credit derivatives: Structure, evolution, motivations, and economics

Credit risk: The challenge of our times

Derivatives: The building block of credit derivatives

Securitization: The other building block

Instruments of credit risk transfer

Meaning of credit derivatives

The elements of a credit derivative

Quick introduction to the types of credit derivatives

Credit derivatives and traditional financial guarantee products

Credit derivatives and credit insurance

Credit derivatives and loan assignments

Credit derivatives and securitization

Motivations

Economic impact of the credit derivative market

Appendix 1

Chapter 2: Credit derivatives: Market, evolution, and current status

Evolution of credit derivatives

Current state of the market

Major centers of credit derivatives activity

Major market players

Dealers

Hedge funds and credit derivatives

Major products

Reference risks: sovereign versus corporate

Credit quality of reference entities

Physical versus cash settlements

Part 2: Single-name instruments

Chapter 3: Credit default swaps

Meaning of CDS

Summary of terms

Main terms of the CDS

Funded CDS

How do the parties to a CDS encash value?

CDS on sovereign names

Basket default swap

Portfolio CDS

Structured portfolio default swap

Binary swaps

Chapter 4: Total rate of return swaps

Meaning of TROR swaps

CDS and TROR swaps

Impact of a TROR swap

Terms of a TROR swap

Examples of applications of TRSs

Advantages of a TRS

Index-based TRSs

Structured TRS

TROR swaps and equity swaps

TROR swaps and property derivatives

TRSs and camouflaged lending transactions

Chapter 5: Credit-linked notes

Meaning of a CLN

Distinctive features of CLNs

Structured risk transfer through CLNs

CLNs issued by SPVs

Self-referenced CLNs

Chapter 6: Credit default swaps on asset-backed securities and derivatives exposures

Need for CDSs on asset-backed securities

Development of CDSs on ABS

Major differences between CDS of ABS and corporate debt

Documentation templates for different structured finance products

Special features in the documentation templates

Notional value of the swap

Credit events in the case of ABS

Two modes of settlement: PAUG and traditional

CDS of CDOs

Contingent CDS

Chapter 7: Loan-only CDS

Meaning of leveraged loans

The LCDS market

Motivations of parties

Distinctive features of LCDS as compared to vanilla CDS

ISDA documentation for LCDS

LCDS basis

LCDX

iTraxx LevX

Chapter 8: Credit derivatives options and volatility trades

Credit spread trades

Credit default swaptions

Payer option

Receiver options

Combination trades

Constant-to-maturity CDS

Chapter 9: Equity default swaps, recovery swaps, and other exotic products

Equity default swaps

Preferred default swap

Recovery swaps

Part 3: Portfolio products

Chapter 10: Portfolio credit derivatives and introduction to structured credit trading

Portfolio credit derivatives vs. single-name credit derivatives

Key features of portfolio formulation

Number and sizing of the tranches

Range of structured credit products

Funded and unfunded transactions

Special purpose vehicles (SPVs)

Chapter 11: Introduction to collateralized debt obligations

Terminology: CDO, CBO, and CLO

Types of CDOs

Typical structure of a CDO

Basic economic drivers of CDOs

Growth of the CDO market

Balance sheet CDOs

Arbitrage CDOs

Measures of pool quality

Asset and income coverage tests

Ramp-up period

The CDO manager

Resecuritization or structured finance CDOs

Collateral and structural risks in CDO investing

Chapter 12: Index trades

Reasons for popularity of index trades

Development of the index trades

Tranche trading

Index options and tranche options

iTraxx Europe

iTraxx Asia

iTraxx total return indices

LevX

Eurex iTraxx credit futures

CDX

ABX

CMBX

LCDX

TABX

Other indices

Index spreads and intrinsic spreads

Chapter 13: Single-tranche synthetic CDOs, CPDOs, and other CDO innovations

Single-tranche synthetic CDOs

Delta hedging

Why would structurers prefer single-tranche structures?

Distinction between a traditional CDO and STCDO

Credit CPPI CDO

CPDOs

CPDOs: from boom to bust

Leveraged super senior CDOs

Long/short CDO

Collateralized commodity obligations

Chapter 14: CDO case studies

Balance sheet synthetic transactions

DBS Bank’s Alco 1

CAST 1999-1 Non-SPV structure

Promise program by KfW Germany

Standard Chartered Bank’s START series and Sealane (Trade Finance) transaction

Synthetic credit asset securitization: SMART from Australia

ANZ’s Resonance Funding

Arbitrage synthetic transactions

Jazz synthetic arbitrage CDO

Robeco arbitrage synthetic CDO

STRUCTURED FINANCE CDOS

Chapter 15: Credit derivative product companies

Development of rating-oriented vehicles

Derivative product companies: A general introduction

Credit derivative product companies: Development

Typical structure of CDPCs

Rating agencies’ conditions for CDPCs

Constitutional and legal structure

Operating modes

Case study: Primus Financial

Quadrant Structured Credit Products

Part 4: Pricing and valuation of credit derivatives

Chapter 16: Approaches to quantification of credit risk

Credit risk: semi analytic approaches

Option-theoretic models

Intensity or hazard rate models

Chapter 17: Pricing of a single name credit derivative

Establishing multi-period probabilities of default

Pricing of a credit default swap

Introducing details

Pricing of a derivative vs. pricing of a bond

Relevance of recovery rate

Valuation of a credit default swap

Value of upfront payment in a CDS

Endnote

Chapter 18: Pricing of a portfolio credit default swap

Basic principles of pricing of portfolio default swaps

A portfolio without correlation

Simulation method to derive probability distribution

Introducing correlation

Correlation and tranche pricing

Market implied correlation and correlation trading

Part 5: Legal, regulatory, operational, tax, and accounting aspects

Chapter 19: Legal aspects of credit derivatives

Legal nature of credit derivatives

Enforceability of credit derivative contracts

Whether credit event?

Meaning of different credit events

Legal disputes on credit derivatives

Derivatives-related regulation applicable to credit derivatives

Legal nature of total return swaps

Legal nature of credit-linked notes

Credit derivatives: Legal authority for banks

Legal authority of a party to enter into a derivative

Legal position of netting rights

Bankruptcy Code: a safe harbor to credit derivatives

Collateral rights

UK insolvency law and netting

EU law on collateral and netting

Netting in other countries

Assignment and novation

Choice of law

Restructuring credit event

Modified restructuring definition

Modified Modified Restructuring

Chapter 20: Documentation for credit derivatives

Overview of derivatives documentation

Legal impact of master agreements

Key features of the ISDA Master Agreement

ISDA documentation for credit derivatives

Documents in case of specific credit derivatives

Novation protocol

Credit support agreement

Chapter 21: Taxation of credit derivatives

The tax basis of credit derivatives

Key issues in taxation of CDSs

Taxation of the protection buyer

Taxation of the protection seller

Mark-to-market rules

Tax treatment in other countries

Taxation of derivative transactions in UK

Taxation of CLNs

Tax treatment of closeout settlement

Chapter 22: Accounting for credit derivatives

Whether derivatives accounting standards are applicable?

Basics of derivative accounting rules

Accounting for CDSs

Accounting for the TROR swap

Accounting for a CLN

Valuation of credit derivatives

Chapter 23: Regulatory capital and other regulations on credit derivatives

Evolution of regulations

Basel II and credit derivatives

Chapter 24: Operational issues

Credit derivatives procedures

Master Agreements

How trade is done

Netting of payments and centralized clearing services

Assignments and novations

The operational risk issue

Chapter 25: Credit derivatives terminology

Index

FOREWORD

Vinod Kothari's treatise on Credit Derivatives and Structured Credit Trading is one of the most complete treatments of this important and largest derivative market in the world today. As such, it provides both a primer and subtle analysis of a market which has garnered both praise and scorn in recent years. For example, credit default swaps (CDS), the most important product in the credit derivative market by far, has been hailed as the most liquid and timely expression of the credit market's assessment of default and loss risk of companies and their credit instruments. The cost of insuring against a credit event is a continuous and up-to-date indicator of market sentiment reflecting fundamental, structural and market commentary changes on a company's probability of defaulting on its outstanding obligations. For example, the implied probability of default on General Motor Corporation's outstanding indebtedness for one year went from about 38 percent to over 90 percent when the company declared that unless the US government supplied a bailout in December 2008, it would run out of cash by year's end. Instantaneously, the upfront payment that CDS buyers had to pay “shot-up,” reflecting the immediacy of the risk. Fundamental default risk models like my Z-Score or KMV's EDF model cannot change as quickly although both do capture new information's impact on the share price of company's common stock.

Speaking of the implied probability of default (PD), Kothari's treatment of the main approaches to the quantification of credit risk (Chapter 16) is an adequate primer of the two techniques noted above (Z and EDF). The CDS market also provides important market estimates of PD. One can solve for the implied PD, given an assumption of the expected recovery rate (RR), (the price 30-day post-default) and the necessity that the expected loss from a default (PD x 1-RR) must equal the present value of the payments that the CDS buyer pays to the seller. The latter is equal to the upfront premium (if any) plus the present value of the quarterly payments until the contract expires. It should be noted that while this implied PD is a more timely assessment of default risk than Z and KMV, it also is much more volatile, and can change dramatically based on rumors and market intangibles, such as liquidity fears and credit rationing.

One of the criticisms of the credit derivative market is the fact that most trades are done over-the-counter and not on listed exchanges. As such, the counterparties and other risk components are not transparent, which adds to the possible systemic risk of a market meltdown. Regulatory officials have been concerned with this risk element for years, especially since the market grew dramatically. The expected result is likely to be more regulation and efforts to remove the intrinsic opaqueness of an OTC market. We will soon have in place a centralized clearing house for CDS trades, thereby reducing counterparty risk. No doubt, the concern about AIG's counterparty exposure played a major role in the decision by the US Treasury to bailout that global insurance giant in September 2008.

We are now in the midst of the most serious credit crisis in at least 80 years and the role of credit derivatives is central to the future of financial markets and its impact on the world's real economy. No doubt, the volume of credit derivative activity will shrink in the near term as the number of major financial institution market makers also shrinks and the ability of the surviving institutions to provide credit risk insurance is constrained by their own capital adequacy problems. Still, it is clear to me that the role of credit derivatives will remain a fundamental and important part of global financial markets, although I expect that structured credit trading will be constrained for several years to come. As such, a clear understanding of these instruments and markets is a must for any serious analyst and market practitioner, as well as students of finance. Kothari's volume should be a standard reference for all of us.

Edward I. Altman

Max L. Heine Professor of Finance

Director of Credit & Debt Markets Research

NYU Salomon Center, Stern School of Business

January 2009

PREFACE

This is the revised edition of the book; the first edition appeared more than six years ago under the title Credit Derivatives and Synthetic Securitization. I have taken considerable time in completing the present edition, and I was all the time chasing a moving target. Market conditions changed drastically between the time I started and finished work on the revision, and every time the edits or the proofs would come, there was something new to write about, and there was something old to scrap.

The world of credit derivatives has undergone a metamorphosis over the past two years, but that is not limited to credit derivatives or derivatives in general. The entire economic scenario has changed. There are lots of casualties all around—institutions, beliefs, products, and many others. Credit markets in general have been under pressure not seen in decades in the past. Credit derivatives volumes have been registering a decline almost all through 2008, and recent data on DTCC trade information warehouse shows the decline is accelerating. This may be partly explained by settlements on some of the major credit events that have taken place in September and October 2008, but at least partly responsible is the scare that investors who bought highly leveraged tranches and first-to-default products and suffered huge mark-to-market or real losses.

Credit derivatives like all derivatives are concerned with volatility or risk. In life around us, risks, as well as awareness of risk, are increasing, and therefore, it is logical to expect that as the road becomes bumpier, the market for risk should increase. However, for the same reason, the appetite for risk-taking suffers. The market for risk-buying that exists in several spheres—property, casualty, life, epidemics, catastrophes, financial variables, credit risk, prices, and innumerable other varieties—has been helped by mathematical models that seek to quantify the probability distribution of occurrence of extreme events, or the so called tail risk. In every period of volatility, the mathematical models that compute the tail risk go haywire, as this period brings such facts or combination thereof that was never predicted. After all, that is precisely what uncertainty is. So, while the model-writers go back to their computers to develop new models that are now wiser but would still incorporate only things that have happened historically, the market for risk-taking suffers.

Credit, and therefore, credit risk, remains the basis on which the present-day economic system works. Credit derivatives have provided a way to slice the risk into bits and pieces. From the simplest idea of separating the risk of default of a credit asset from the asset itself, the market has evolved ways of trading in timing of default, correlation among several credits, risk of recovery rates, sensitivity of different slices of the risk to changes in credit spreads, sensitivity of different layers of the capital structure to the well-being or otherwise of an entity, and so on. Needless to say, this development would continue to gather strength, after the knee-jerk reaction of widening of credit spreads all across recedes. The current period of volatility and massive bank failures, liquidation of collective investment devices, and redemption of hedge funds would possibly motivate regulators to respond in form of new sets of regulation, mostly perfunctory. However, there is little doubt that as long as credit remains the mainstay of global economy, devices to replicate and trade in such risk will continue to be of relevance.

Before I present this work to the reader, I must place most well-deserved gratitude to the editorial staff at Wiley, who have been extremely patient with me.

I would look forward to any constructive feedback that readers may like to provide.

Vinod Kothari

Kolkata

February 2009

Part 1

Market, instruments, and motivations

Chapter 1

Credit derivatives: Structure, evolution, motivations, and economics

Life is either a daring adventure or nothing. Security does not exist in nature, nor do the children of men as a whole experience it. Avoiding danger is no safer in the long run than exposure.

Helen Keller

US blind & deaf educator (1880–1968)

Credit derivatives, an instrument that emerged around 1993–94, are a part of the market for financial derivatives. Since credit derivatives are mostly not traded on any of the organized exchanges, they are a part of the over-the-counter (OTC) derivatives market, even though attempts at exchange trading are currently on. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative, the reasons for which are not difficult to understand.

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty to the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitization. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

The counterparty to a credit derivative product that acquires exposure to the risk synthetically acquires exposure to the entity whose risk is being traded by the credit derivative product. Thus, the credit derivative trade allows people to trade in the generic credit risk of the entity, without having to trade in a credit asset such as a loan or a bond. Given the fact that the synthetic market does not have several of the limitations or constraints of the market for cash bonds or loans, credit derivatives have become an alternative parallel trading instrument that is linked to the value of a firm—similar to equities and bonds. Equities allow trading in the residual value of the firm. Debt allows a trade in the debt of a firm. Credit derivatives allow a trade in the risk of default or bankruptcy of a firm.

Coupled with the device of securitization, credit derivatives have been rendered into investment products. Thus, investors may invest in credit-linked notes (CLNs) and gain credit exposure to an entity, or a bunch of entities. Securitization linked with credit derivatives has led to the commoditization of credit risk.

Apart from commoditization of credit risk by securitization, there are two other developments that seem to have contributed to the exponential growth of credit derivatives—index products and structured credit trading.

In the market for equities and bonds, investors may acquire exposure to either a single entity’s stocks or bonds, or to a broad-based index. The logical outcome of the increasing popularity of credit derivatives was the development of credit derivatives indices. Thus, instead of gaining or selling exposure to the credit risk of a single entity, one may buy or sell exposure to a broad-based index, or sub-indices, implying risk in a generalized, diversified index of names.

The idea of tranching or structured credit trading is essentially similar to that of seniority in the bond market—one may have senior bonds, pari passu bonds, or junior bonds. In the credit derivatives market, this idea has been carried to a much more intensive level with tranches representing risk of different levels. These principles have been borrowed from the structured finance market. Thus, on a bunch of 100 names, one may take either the first 3 percent risk, or the 4–6 percent slice of the risk, or the 7–10 percent slice, and so on.

The combination of tranching with the indices leads to trades in tranches of indices, opening doors for a wide range of strategies or views to take on credit risk. Traders may trade on the generic risk of default in the pool of names, or may trade on correlation in the pool, or the way the different tranches are expected to behave with a generic upside or downside movement in the credit spreads, or the movement of the credit curve over time, etc.

Quite often, the development of the hedge fund industry has been associated with the development of credit derivatives. Hedge funds are prominent in credit derivatives trades, particularly in the case of the lower tranches of the structured credit spectrum. The hedge fund industry represents the segment of investor capital that is least regulated, risk neutral, out to seize opportunities arising out of mis-pricing, and so on. As the credit derivatives trades are almost completely unregulated and offer opportunities of short trades in credit not permitted by the bond market, the credit derivatives industry provides an excellent playing ground for the hedge funds.