Antulio N. Bomfim

Credit-linked notes

Credit-linked notes (CLNs) are essentially securities structured to mimic closely, in funded form, the cash flows of a credit derivative. CLNs have a dual nature. On the one hand, they are analogous to traditional coupon-paying notes and bonds in that they are securities that can be bought and sold in the open market and that promise the return of principal at maturity. On the other hand, they can be thought of as a derivative on a derivative, as a CLN’s cash flow is tied to an underlying derivative contract.

Total Return Swaps

In a total return swap (TRS), an investor (the total return receiver) enters into a derivatives contract, whereby it will receive all the cash flows associated with a given reference asset or financial index without actually ever buying or owning the asset or the index. The payments are made by the other party in the TRS contract, the total return payer. Unlike an asset swap, which essentially strips out the credit risk of fixed-rate asset, a TRS exposes investors to all risks associated with the reference asset—credit, interest rate risk, etc. As such, TRSs are more than just a credit derivative. Nonetheless, derivatives dealers have customarily considered their TRS activity as part of their overall credit derivatives business.

Principal-Protected Structures

Principal-protected structures are coupon-paying financial products that guarantee the return of one’s initial investment at the maturity of the structure, regardless of the performance of the underlying (reference) assets. The coupon payments themselves are stopped in the event of default by the reference entity. Principal-protected structures can be thought of as a form of a funded credit derivative.

Valuing credit options

This chapter describes a relatively simple framework for valuing spread and bond options. It starts with a discussion of forward-starting credit default swaps, introducing some concepts that will come in handy in the valuation of credit default swaptions. The chapter also generalizes the valuation approach for credit default swaptions so that it can be used with other spread options. It also describes extensions and alternatives to the simple framework and sketches out the valuation of bond options. Forward-starting credit default swaps can be thought of as the underlying asset in a credit default swaption, and thus, it will be instructive to have a basic understanding of the way they are valued before proceeding to examine the valuation of credit default swaptions. The same idea applies to forward contracts written on floaters, which the chapter examines them in some detail. The chapter also discusses the valuation of options written on floating-rate bonds and on credit default swaps.

The Credit Derivatives Market

The market for credit derivatives has undergone enormous changes in recent decades. It had been growing spectacularly in the years leading up to the 2008 financial crisis, but the crisis left a lasting imprint on the market. This chapter provides an overview of the main forces that have helped shape the credit derivatives market over the years. We also discuss the major types of market participants and take a quick look at the most common instruments, practices, and conventions that underlie activity in the credit derivatives market.

Portfolio default swaps

Portfolio default swaps are similar to basket swaps in that they transfer portions of the credit risk associated with a portfolio from a protection buyer to a protection seller. However, a key difference between portfolio default swaps and basket swaps is that in portfolio default swaps, the risk transfer is specified in relation to the size of the default-related loss in the reference portfolio instead of in terms of the number of individual defaults among the reference entities. Whereas protection sellers in a first-to-default basket are exposed to the first default in the reference basket, protection sellers in a first-loss portfolio default swap are exposed to default-related losses that amount up to a prespecified share of the reference portfolio. From the perspective of investors, portfolio default swaps allow one to take a substantially leveraged exposure to credit risk—and thus earn a higher premium—with only limited downside risk. Portfolio default swaps are attractive to protection buyers because they allow the transfer of a substantial share of the credit risk of a portfolio through a single transaction, as opposed to a large number of individual transactions. In addition, similar to basket swaps, a portfolio default swap can be a cost-effective way of obtaining partial protection against default related losses in ones portfolio. This chapter discusses the basics of portfolio default swaps and lays some of the groundwork for discussing synthetic collateralized debt obligations (CDOs).

The Credit Curve

One can derive risk-neutral survival probabilities from the prices of liquid credit market instruments and then use such probabilities to price other, less liquid or more complex, instruments. This chapter describes a relatively straightforward framework for inferring survival probabilities from quoted credit default swap (CDS) premiums. It focuses on three progressively simpler methods: one that can handle any shape of the term structure of CDS premiums, one built on the assumption of a flat term structure of CDS premiums, and one based on a simple rule of thumb for quick, back-of-the-envelope calculations for highly rated reference entities. CDS has two “legs”: the premium leg is made up of the periodic payments made by the protection buyer, and the protection leg is the default-contingent payment made by the protection seller. The chapter provides examples that illustrate several practical applications of credit curves, ranging from using CDS-implied survival probabilities to determine the fair values of coupons on principal protected notes to marking existing CDS positions to market.

Valuing defaultable bonds

Before we start exploring specific models for pricing credit derivatives, we will pause to introduce some notation and, in the process, review a few important concepts. Those familiar with risk-neutral probabilities and the risk-neutral valuation approach, two of the most important topics discussed in this chapter, may still want to at least glance through the next few pages to familiarize themselves with the notation that will be used throughout this part of the book.

Main Credit Modeling Approaches

This chapter reviews the credit risk literature with a special focus on the main modeling approaches for valuing instruments subject to default risk. The so-called firm value or structural approach to credit modeling traces its origins back to the work of Black and Scholes and the work of Merton. Credit models in this tradition focus on the analysis of the capital structure of individual firms in order to price their debt instruments. The discussion of the structural approach relies on some basic results regarding vanilla call and put options. In the chapter, most of these results are discussed only at an intuitive level. The reduced-form or default-intensity-based approach is also addressed in the chapter. The reduced-form approach does not directly attempts to link defaults to the capital structure of the firm. Instead, it models defaults to be exogenous stochastic events. Work in this strand of the credit risk literature is primarily interested in developing essentially statistical models for the probability of default over different time horizons. The chapter briefly compares the structural and reduced-form approaches both on methodological and empirical grounds. It also highlights the main thrust of a hybrid approach, motivated by the work of Duffie and Lando that incorporates elements of both the structural and reduced-form approaches.

Anatomy of a CDS Transaction

This chapter provides an overview of the legal and documentation issues involving credit default swaps (CDS), the most prevalent of all credit derivatives. Similar to other over-the-counter derivatives instruments, CDS are typically initiated with a phone call in which the basic terms of the transaction are agreed upon by the two prospective counterparties. CDS contracts are largely standardized, with the marketplace mostly relying on documentation sponsored by the International Swaps and Derivatives Association (ISDA), a trade group whose members include major dealers and end-users of over-the-counter derivatives products ranging from interest rate swaps to credit derivatives. To appreciate the role that the so-called ISDA contracts for CDS have played in the development of the credit derivatives market, it is useful to imagine the counterfactual. The ISDA framework for credit default swap contracts revolves around several components such as the master agreement, the confirmation letter, and so on. The legal framework sponsored by ISDA is primarily intended to promote standardization of legal provisions and market practices, but it recognizes that some of the legal stipulations of the transaction may need to be tailored to the needs of the counterparties.