Local banks can take advantage of their informational edge in terms of assessing the default risk and recovery rates in their regional market. They make loans based upon this credit assessment and then use credit derivatives to swap these cash flows for more internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk. Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate debt. This is just one example.
Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve. The credit spread is volatile in and of itself and it may be correlated with the level of interest rates. For example, in a declining, low interest rate environment combined with strong domestic growth, we might expect corporate bond spreads to be smaller than their historical average. The corporate who has issued the bond will find it easier to service the cash flows of the corporate bond and investors will be hungry for any kind of premium they can add to the risk-free rate.
Imagine the fund manager who specializes in corporate bonds who has a view on the direction of credit spreads on which he would like to act without taking a specific position in an individual corporate bond or a corporate bond index.
One way for the fund manager to take advantage of this view is to enter into a credit swap.
Let's say that the fund manager believes that credit spreads are going to tighten and that interest rates are going to continue to decline.
He would then want to enter into a swap in which he paid the corporate yield at six-month intervals against receiving a fixed yield equal to the inception Treasury yield plus the corporate credit spread. That is to say, at the six-month reset for the tenor of the swap, the fund manager agrees to pay a cash flow determined to be equal to the current annual yield on some benchmark corporate bond or corporate bond index in consideration for receiving a fixed cash flow.
This is an off-balance sheet transaction and the swap will typically have zero value at inception.
If corporate yields continue to fall (i.e. through a combination of a lower risk-free rate and a lower corporate credit spread than the one he locked in with the swap), he will make money. If corporate yields rise, he will lose money.
1998 was a dynamic year for corporate bond spreads with the backup in interest rates in the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainly in corporate yields. The volatility of these spreads was extreme when compared to their historical movement. Credit swaps would have been an excellent way to play this spread volatility.
Moreover, credit swaps (particularly ones based on a spread index) are clean structures without the messy difficulty of finding individual corporate bond supply, etc.
Another example of a credit swap might be the exchange of fixed flows (determined by the yield on a corporate bond at inception) against paying floating rate flows tied to the risk-free Treasury rate for the corresponding maturity.
Naturally, swaps are flexible in their design. If you can imagine a cash flow exchange, you can structure the swap. There might be a cost associated with it but you can certainly put it on the books.
CREDIT DEFAULT SWAPS
A credit default swap is a swap in which one counterparty receives a premium at pre-set intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place.
One possible type of credit event for a credit default swap is a downgrade in the credit status of some preset entity.
Consider two banks: First Chilliwack Bank and Banque de Bas.
Chilliwack has made extensive loans in its corporate credit portfolio to a property developer called Churchill Developments. It is looking for some kind of insurance against a downgrade of Churchill by the major ratings agency, a real possibility since the main project Churchill has taken on is running into unforeseen delays. Chilliwack approaches Banque de Bas with the concept of a credit default swap. They pay Banque de Bas a premium every six months for the next five years in exchange for which de Bas agrees to make payments to Chilliwack of a pre-set amount should Churchill be downgraded.
De Bas now has exposure to Churchill, a position they could not take directly because they are not part of Churchill's lending syndicate.
Chilliwack has some degree of protection against a Churchill credit downgrade. This reduction in their overall credit profile means that they do not need to hold as much capital in reserve, freeing Chilliwack up to take other business opportunities as they present themselves.
OPTIONS ON CREDIT RISKY BONDS
Finally, our fund manager from the first example could use an options position to take advantage of his view on the level of the corporate yield.
If he believed that corporate yields were set to fall through some combination of lower risk-free interest rates and tighter corporate bond spreads, then he could just buy a call on a corporate bond of the appropriate maturity.
These are just a few of the examples of credit derivatives. Institutional investors often use credit derivatives when positioning themselves in emerging markets for the ease of transaction in the same way that they might use equity swaps. Fund managers can use credit derivatives to hedge themselves against adverse movements in credit spreads. Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banks and other financial institutions can use credit derivatives to optimize the employment of their capital by diversifying their portfolio-wide credit risk.
Article by Chand Sooran, Principal Victory Risk Management Consulting, Inc.