by Sunil K. Aggrawal

Over the years, Wall Street's financial wizards have continually responded to the markets’ demand for more efficient financing tools that allow corporations to either lower their cost of funds, take advantage of special tax situations or access a new lending base. In the early 1980s the interest rate market began a new wave of financial innovation with the development of the swap market, which provided reduced credit margins for borrowers in different markets while allowing derivative houses to gain profits through their role as intermediaries. At each phase of the swap market's development, new interest rate derivatives to were added to product menus. For example, vanilla interest rate swaps paved the way for cross currency swaps bringing the foreign exchange markets into the field and flat-forward foreign exchange contracts contributed to the emergence of the energy swaps market. In each of these cases, the market was bundling, unbundling, repackaging and transferring risk between counterparties.

One of the latest crazes to hit the market has been the introduction of credit derivatives, mechanisms that allow institutions to unbundle the credit risk portion of traditional debt instruments from market risk in an effort to improve pricing efficiency. Sections 1 and 2 will provide descriptions of the credit derivatives market and the basic instruments that are trading today. Section 3 offers a more detailed description of two applications of these derivatives that will fuel much of the growth in trading volume over the next few years, loan portfolio management and merger and acquisition deals. These cases begin with a description of the situation facing the counterparties involved and then demonstrate how a customized credit derivative can be applied. The last two sections provide insight into the more pragmatic side of the business where dealers work around pricing, hedging, documentation and regulatory obstacles to put deals together.

While this paper attempts to provide a comprehensive commentary on the state of the credit derivatives market today, the research is by no means exhaustive and access to information on the latest cutting edge trade in these markets can be difficult to obtain. As with a personal computer purchased two months ago, once one understands everything it can do, the PC is probably obsolete. In the derivatives markets, once a list of all the trades in the market has been compiled, its participants have come up with five or ten new ones.

1. Credit Derivatives

1.1 What are Credit Derivatives?

Credit derivatives are privately negotiated bilateral contracts that allow users to manage their exposure to credit risk. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books. This mechanism can be used for any debt instrument or a basket of instruments for which an objective default price can be determined. In this process, buyers and sellers of the credit risk can achieve various objectives, including reduction of risk concentrations in their portfolios, and access to a portfolio without actually making the loans. Credit derivatives offer a flexible way of managing credit risk and provide opportunities to enhance yields by purchasing credit synthetically. Credit derivatives cannot eliminate all credit risk because inherent in the transfer of a loan exposure to Company A, is the introduction of a new exposure to Company B because of the use of a derivative with Company B. Generally, AAA-rated Special Purpose Corporations or Vehicles (SPCs or SPVs) are created to enter into such transactions to reduce the new exposure. Examples of credit derivatives include Credit Linked Notes (CLNs), Total Return Swaps (TRSs), Credit Default Puts, Credit Spread Options and others which will be discussed in Section 2.

1.2 What is Credit Risk?

Credit risk is the possibility that a borrower will fail to service or repay a debt on time. The degree of risk is reflected in the borrower's credit rating, which defines the premium over the riskless borrowing rate it pays for funds and ultimately the market price of its debt. Credit risk has two variables: market risk and firm-specific risk. Credit derivatives allow users to isolate, price and trade firm-specific credit risk by unbundling a debt instrument or a basket of instruments into its component parts and transferring each risk to those best suited or most interested in managing it. There are various traditional mechanisms to reduce credit risk including refusal to make a loan, insurance products, guarantees and letters of credit, but these mechanisms are less effective during periods of economic downturn when risks that normally offset each other simultaneously default and financial institutions suffer substantial loan losses.

1.3 Estimated Market and Active Players

Credit derivatives have emerged as a major risk management tool in recent years. The total volume outstanding of credit derivatives is estimated to exceed $75 billion. Once largely confined to banks, the market participants have expanded to include insurance companies, hedge funds, mutual funds, pension funds, corporate treasuries and other investors looking for yield enhancement or credit risk transference. The market has evolved from the financial institutions' needs to manage their illiquid credit concentrations and their use of default puts to hedge their credit exposure. Existing derivative techniques have been used for emerging market debt and have further been applied to corporate bonds and syndicated bank loans. Total Return Swaps, for example, were developed to sell customized exposures to investors looking for a pick-up in yields on their portfolios. These structures enable investors to obtain exposure to portfolios which were not available to them previously and provides them with new diversification opportunities.

Several factors have contributed to the development of the credit derivative market. Investors have shown interest in these products for yield enhancement given the increasingly narrow credit margins on conventional corporate and emerging market sovereign issues. As investors have come to understand these products more fully, trading volumes have increased. Now dealers are more frequently warehousing trades in the same way they warehouse and manage interest rate risk. Over-the-counter brokers have entered the market and the International Swaps and Derivatives Association (ISDA) is responding to the call for standardized documentation.

Comments from most market participants indicate a consensus expectation of continued growth and increased liquidity in the future. Credit derivatives will make credit risk pricing more efficient, much as Collateralized Mortgage Obligations (CMOs) did for mortgage pricing, and help segregate credit risk from market risk in bond and loan pricing. Institutions best suited to handle the credit risk component of these debt instruments will be able to buy only that portion of the risk and warehouse it.

2. Types of Credit Derivatives

The product menu in the credit derivatives market is changing every day, but there are four major instruments that make up the bulk of the trading volume today: Total Return Swaps, Credit Default Swaps, Credit Spread Options and Credit Linked Notes. Terminology varies among market participants, sometimes based on geography. For example, Credit Default Swaps are sometimes called Credit Swaps so it is difficult to maintain a consistent lexicon when discussing this developing market. Traders and marketing staff are careful to provide detailed descriptions of a transaction-specific payoff profile so it is of more value to understand under what circumstances one will receive a payment, or be required to make one, than it is to know a list of product names.

Table 1, from the British Bankers' Association, provides estimates of how credit derivative trading volume breaks down by product type. Of most interest in this chart is their view of the likely trend in the market which favors the development of products which allow end users to manage their borrowing spread over the risk-free rate. With a broad menu of products for corporate treasurers to manage their absolute exposure to the level of interest rates (swaps, caps, collars), they will next look for ways to stabilize their company's borrowing spreads.

Table 1
Credit Derivatives’ Share of the Market
By Product

2.1 Total Return Swaps (TRSs)

A Total Return Swap is a derivative instrument that allows an investor to receive the total economic return of an asset (income plus or minus any change in capital value) without actually buying the asset. Exhibit 1 is a diagram of TRS cash flows. One party pays the total economic return on a notional amount of principal to another party in return for periodic fixed or floating rate payment (plus some spread). The underlying reference credit (e.g. LIBOR) can be any financial asset, basket of assets or an index. There can be many variations on the basic TRS structure. For instance, one can use a basket of assets instead of a single credit. Maximum and minimum levels for the floating rate leg of the structure can be set via embedded caps on a reference credit. Maturity of these swaps generally runs from one to three years.

Exhibit 1 Total Return Swap Cash Flows

Banks use this product as a way of transferring the risk exposure of an asset to another interested party. Investors seeking exposure to a bank portfolio use TRSs to enhance their yield. For example, a bank might agree to pay total return on a $50 million loan portfolio to an insurance company in exchange for semi-annual payments of LIBOR plus 100 basis points. This allows the bank to reduce its exposure to the credit risk portion of the portfolio without selling the loans. The insurance company, on the other hand, obtains exposure to the portfolio without bearing the expense of originating and administering these loans, except via the bank's margin on the swap. The swap enables banks to keep the entire asset on their books, but maintain only the desired amount of credit exposure. Why is this of value to the banks in an era when return on assets is so carefully scrutinized by equity analysts? It seems on the surface that they would look to move as much off their balance sheet as possible. In many cases, banks want to keep the loans on their books to avoid jeopardizing their relationship with a customer or breaching client confidentiality.

Investors can leverage and diversify their portfolios to achieve higher yields by taking on this credit exposure. A TRS enables the investor to make loans synthetically without the administrative burden of documenting the loan agreement and periodically resetting the interest rate. TRSs can provide an extremely economic way of using leverage to maximize return on capital. The investors do not have to put up $50 million to gain exposure to a $50 million bank portfolio. The exposure on an interest rate is not as large as its notional principal amount since only the respective interest payments are made. Only the total return of the portfolio is exchanged with the fixed or floating semiannual payments. Table 2 is an example of the cash flows of a typical TRS.

Table 2 Total Return Swap Cash Flow Example

An investor desiring exposure to a 10-year BBB corporate bond enters into a 6-month TRS.

All-in Bond Price/Notional Amount 102

2.2 Credit Default Swaps (CDSs) a.k.a. Default Puts

A Credit Default Swap is another mechanism for distributing the default risk of securities and loans, enabling lenders and investors to improve risk management and better achieve their financial goals. In this case, one party makes periodic basis points payments and another party makes payments for the principal if the "credit default" event occurs. The pricing of such a derivative depends upon the credit quality of the reference credit, supply and demand for the reference credit, and prevailing credit spreads. The objective might be any of the following: to sell a specific risk, e.g. country risk in a project finance transaction, to free up credit lines for a specific customer, to pick up additional yield by assuming the credit risk, to improve portfolio diversification, to gain exposure to credits without buying the assets or to assume an off-balance-sheet synthetic position. Exhibit 2 is a CDS cash flow.

Exhibit 2 Credit Default Swap Cash Flows

Banks that want to reduce or eliminate their exposure to a particular loan or basket of loans can buy a CDS without the borrower's knowledge or consent (which may be required when the loans are sold outright). Manufacturing companies that depend upon a limited number of customers for revenue can buy a CDS on their customers' payment obligations. Investors who need to protect themselves against default but cannot or do not want to sell the at-risk security for accounting, tax or regulatory reasons, can buy a Credit Default Swap. Investors can pick up additional yield without buying an asset, holding it on their balance sheet and funding it. Building on the basic swap structure, investors can swap the default risk of one credit with that of another credit. This can help companies diversify their portfolios while avoiding the transaction costs associated with buying and selling many individual securities or loans.

Credit events in such transactions are pre-defined in the agreement, which could include a payment default, bankruptcy or debt rescheduling. The credit event must be material and objectively measurable, this has been one of the major issues addressed by the International Swaps and Derivatives Association (discussed in Section 5). The reference credit can be almost any loan or security, a basket of loans or securities, regardless of the currency, and the tenure of the swap can match or be shorter than the tenure of the reference credit.

2.3 Credit Spread Options

Buying or selling an option on a borrower's credit spread provides an opportunity to gain exposure on the borrower's future credit risk. One can lock in the current spread or earn premium for the risk of adverse movement of credit spreads. It also presents a method of buying securities on a forward basis at favorable prices. Credit Spread Options are normally associated with bonds, which are priced and traded at a spread over a benchmark instrument of comparable maturity. The yield spread represents the risk premium the market demands for holding the issuer's bonds relative to holding riskless assets like U.S. Treasuries. Options can refer to the borrower's spread over U.S. Treasury Bonds, LIBOR or any other relevant benchmark.

For example, an investor might sell an option on the credit spread of a BBB-rated corporate bond with 5-year maturity to a bank in exchange for a premium up front. The option gives the bank the right to sell the bond to the investor at a certain strike price (assume 150 basis points). The strike price here is expressed in terms of credit spread over the 5-year Treasury note. On the option's exercise date, if the actual spread of the corporate bond is less than 150 basis points, the option expires worthless. If it is higher than 150 basis points, then the investor delivers the underlying bond and the investor pays the price whose yield spread over the benchmark equals 150 basis points.

This structure allows investors to buy the bonds at attractive terms. If the option expires worthless, the total cost of bond is reduced by the amount of the premium. Otherwise the investor pays for the bond at the chosen strike price. There could be different strategic variations of this, such as (i) using options on credit spreads to take position on the relative performance of two different bonds and (ii) locking in the current spread by buying calls and selling puts on the spread with the possibility of earning a premium in the transaction. Again, this derivative structure allows investors to take a position in the underlying assets synthetically rather than buying assets in the cash market.

Credit spread options also give end users protection in the event of a large, unfavorable credit shift, which falls short of default. Spreads should move to reflect any downgrading in the credit rating. End users who purchased spread options will be able to cash in even though the referenced credit has not defaulted.

2.4 Credit-Linked Notes (CLNs)

The Credit-Linked Note market is one of the fastest growing areas in the credit derivatives sector. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk and investors a higher yield for buying a credit exposure synthetically rather than buying it in the publicly traded debt.

CLNs are created through a Special Purpose Company (SPC), or trust, which is collateralized with AAA-rated securities. Investors buy the securities from the trust that pays a fixed or floating coupon during the life of the note. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. Here the investor is, in fact, selling the credit protection in exchange for higher yield on the note.

The trust on the one hand enters into a default swap with a deal arranger. In the case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee. This annual fee is passed on to the investors in the form of a higher yield on the notes. In this structure, the investors can obtain higher yield for taking the same risk as the holder of the underlying reference credit. The investor does, however, take the additional risk, albeit limited, of its exposure to the AAA-rated trust. The Credit-Linked Note allows a bank to lay off its credit exposure to a range of credits to other parties. J.P. Morgan has completed one of the more noted CLN transactions, which was based on the credit of Wal-Mart.

2.5 Other Credit Derivatives

2.5.1 Asset Linked Trust Securities (ALTS)

These are Special Purpose Vehicles (SPVs) created by Barclay’s Zoete Weld that allow investors to combine securities, loans and other financial assets with a swap or other derivative products to produce customized cash flows. They transform one or more attributes of the underlying asset, or basket of assets, and enable investors to benefit from derivative technology without directly entering into a derivative transaction.

In a typical transaction, each investor purchases an Asset Linked Trust Security (ALTS) certificate, which represents an interest in a separate and independent trust and entitles the investor to participate in the cash flows from the underlying instruments. ALTS trusts can accommodate all kinds of financial assets and credit derivatives and provide the same benefits as the derivative instruments themselves. For example, they allow investors to access the bank loan market without the operational or administrative burdens of syndicated loan participation. They provide a cheaper, simpler and more efficient alternative for investors to diversify their credit exposure through the purchase of a basket of loans or securities and derivatives.

2.5.2 Chase Secured Loan Trust Notes (CSLT)

Chase Secured Loan Trust notes offer investors access to the high-yield bank loan market. One of the attractive aspects of this market to investors is that, while offering double-digit returns in many cases, the senior-secured status of bank loans has given them a very stable, and favorable, default percentage over the years. This is a market that has been widely untapped by institutional investors with only 20 - 25 percent of the $250 billion in syndicated leveraged loans outstanding held by this sector. The Chase structure uses credit derivatives to offer these investors access to this asset class.

Take, for example, an investor who is prohibited from investing in anything lower than investment grade securities. In the Chase structure, the underlying credit derivative is a Total Return Swap between Chase and a trust. Chase pays the trust the total return on a loan portfolio of $100 million for example, which yields LIBOR plus 250 basis points. In exchange, Chase receives LIBOR plus 100 basis points from the trust. An investor who purchases a tranche of the CSLT in the form of a note receives the same return on the loan portfolio that is received by the trust from Chase on the TRS. For this return, the investor does not put up the total $100 million as would be required to participate in actual loan syndication. Rather, the investor pays $20 million for the tranche, which is used by the trust to purchase treasuries to post as collateral against the trust's payment on the TRS. When all the cash flows are broken down on the transaction, including the five times leverage of the $20 million for access to the $100 million loan portfolio plus the yield on the treasuries of 6 percent, the investor generates a total yield in this example of 13.5 percent.

3. Credit Derivatives Applied

3.1 Loan Portfolio Management

Credit risks are one of the most significant risk classes for financial institutions. Until recently, there has not been a developed, liquid market for trading credit risk. Financial institutions have concentrated on their net market exposure sometimes at the expense of increasing the credit risk to certain companies. Credit derivatives allow financial institutions to change their exposure to a range of credit-related risks. As outlined above, there are different structures which allow the transference of credit risk from one party to another. The choice of the product depends upon the goals a financial institution is looking to achieve. In some cases, the bank can buy protection in the form of default puts to transfer the credit risk to an insurance company or other institutional investors. Additionally, the bank may swap one credit for another credit of equal rating, just to reduce its exposure to one party.

A loan portfolio manager can achieve any of the following objectives:

• Control credit risks of any debt instrument or basket of instruments by selling or transferring the credit exposure of the portfolio;
• Reduce a particular risk concentration in the portfolio;
• Create synthetic assets tailored to meet their needs;
• Provide a diverse menu of global exposures to achieve portfolio diversification; or
• Gain exposure to another bank's loan portfolio without participating in the syndicate.

The following example walks through a TRS transaction, starting with the situations of the parties involved, then proceeding to the credit derivative solution.

Party A is a smaller Texas-based bank with a concentration of loans and revolving credit lines to a group of independent oil and gas producers, as well as energy service companies, whose interests are tied heavily to the development of new offshore natural gas field in the Gulf of Mexico. All companies are privately held with their rights to various parcels of the gas field as their primary assets. The bank's original intent was to have a portfolio of approximately $100-$150 million in loans outstanding to undeveloped properties. With several loan officers approving business out of three different offices, current exposure has reached $300 million. Efforts to syndicate the loans have been unsuccessful due to the lack of fallback assets if the properties fail and market perception that the producers should have been sent to the high yield market. While pricing of the loans is favorable averaging LIBOR plus 300 basis points, the bank is looking to reduce its exposure to this loan portfolio.

Party B is a mid-size money management company who caught wind of the development of this new site in the Gulf and is keenly interested in the upside of the property. One of the fund's managers is a close friend with the developer of the current generation of seismic imaging that discovered the gas field and thinks it will be a winner. Efforts to gain an equity stake in any of the small producers with rights to the field were rebuffed, which only served to solidify the manager's conviction that the property will succeed. The fund manager wants exposure to these fields because he thinks the high rate of return the market is pricing into these credits is unjustified. He is looking to tap into the bank's loan portfolio but is prohibited from taking actual loans into the fund portfolio via syndication. He is also looking to leverage up his exposure to the field if possible.

Using a TRS passed through an AAA-rated trust, Party A agrees to pay party B the total return on $100 million dollars worth of the reference loan portfolio. This return will be a function of interest earned on previously distributed loans, future drawdowns of revolving credit agreements and default losses. Party B agrees to pay Party A six month LIBOR plus 150 basis points. Exhibit 3 illustrates these cash flows.

Exhibit 3 TRS Loan Portfolio Cash Flows

In this example, a Chase Secured Loan Trust note could be used to allow the investor to leverage up his position in the loan portfolio, or he could place the full $100 million with Party A. The fund manager who is looking for maximum returns will likely opt for the leveraged position in this instance. The pricing is fairly simple since the spread on the loan portfolio has been established already, the dealer must only factor in the cost of administering the portfolio and his desired return on the swap to arrive at rate on the TRS.

Hedging is not a real issue in this case because the swap from the bank's perspective is reducing credit risk on the loan portfolio and adding credit risk to the fund company. As such, the trade is a form of risk diversification. For the fund manager the situation is much the same: he is gaining access to a credit exposure that he wants and will likely not hedge the position. If hedging were desired on his part, his alternatives would be limited since there are no publicly traded securities of any of the companies in the loan portfolio. This would remove any replication strategies that are commonly used by dealers running hedged books in these markets.

Once the trade is booked, what are some of the system implications for Party A who has now swapped out of some of their loan portfolio risk and added a TRS to its books? If a separate desk manages the derivatives, which is likely, the cash flows and the default percentages on the $100 million worth of loan portfolio must now be monitored. Together, the cash flows and default percentages will determine the payouts to the trust and to the fund. This creates the need for a system to track loans. What if the desk has other credit derivatives that it has hedged with short or long corporate bond positions or equity positions? The particulars of any credit derivative could have the credit derivatives desk relying on daily mark-to-market calculations from various groups in the bank. This can create control problems and make it difficult for the desk to mark their positions in a timely fashion. Reliance on disparate systems with different reporting methods is not ideal and is one of the challenges faced by innovators in this field.

3.2 Merger and Acquisitions Transactions

Credit derivatives are currently actively used for leveraged mergers and acquisitions (M&A) transactions. Lenders who finance such transactions can use credit protection to manage exposure to the acquirer of a target company. The funding exposure can be in terms of bridge financing or a permanent syndicated loan used to finance the transaction.

For example, Company A, the acquirer of the target Company B, intends to finance this acquisition through a syndicated loan of $5 billion. Before a permanent financing could be arranged, Bank C may provide bridge financing for the transaction and possess the credit exposure to Company A. Bank C can enter into a default swap with a Dealer D, or a combination of dealers, to protect itself against the credit of A. Since the transaction size is enormous, no one dealer will buy the whole credit exposure and a combination of dealers is needed.

Another arena where credit derivatives can be used in an M&A transaction is the merger of a stronger credit with a weaker one that will potentially downgrade the credit of the combined firm. A lender that is exposed to stronger credit can buy credit protection or buy a put option on the credit spread of Company A to protect itself from any downgrading of the referenced credit.

Another application of credit derivatives in an M&A transaction is to free credit constraints. For example, Bank C may not be able to provide bridge or permanent financing to the acquirer company A since it has reached the maximum credit limit with A. To free this lending constraint, it can transfer the risk of the existing credit lines by entering into a default swap with other credit dealers. By doing so, it will expand the bank's capacity to assume additional lending and provide the needed M&A financing to Company A.

To hedge the risk of a credit derivative in a large M&A transaction, one can diversify the credit risk by entering into syndication or repackaging the credit risk and sell it off in the credit markets. The pricing of these products is generally done using the benchmarks in the cash markets. If such cash market benchmarks are not available for any particular market, then default probability and recovery rate models are used to price credit derivatives. As per one dealer, option-pricing models have been used to price credit options.

4. Pricing & Hedging Considerations

4.1 Pricing Issues

Credit derivatives sit at the intersection of traditional insurance or guarantee products and the financial derivatives. Each of these areas has their own valuation methodology. Neither of these methodologies is entirely satisfactory for the valuation of credit derivatives. The insurance industry typically uses historical data to value insurance policies relying on actuarial science and the probability of payment-triggering events.

Credit rating agencies have tables of probability of downgrading or default by maturity, which some derivatives practitioners use. These tables, however, are based on strong assumptions: (i) they assume that the future will be like the past, (ii) they do not take into account market information available in the form of credit spreads and (iii) they assume that exposure to different entities is unrelated. On the other hand, derivative dealers use market-based information to price their products. The derivatives community uses this information based on the assumptions of risk neutral valuation and arbitrage-free complete markets. Credit markets are not liquid enough to be perfect, nor is there a complete set of financial instruments available for precise valuation. There is also the question of which stochastic process to assume for different credit events. Do all credit events follow the same processes or are unique processes for each industry or each state of the economy needed? While these are some daunting problems to solve, very little business would get done if the market waited for precise answers. Wall Street’s derivative houses are constantly at work to improve valuation methods, and seek arbitrage opportunities due to mispricing, but there are necessarily some assumptions used in the pricing of credit derivatives. The following is a brief list of some techniques in use today.

Ratings-Based Default Probability Models

These pricing models rely on credit ratings and published data on default losses, such as the Altman Dataset, to approximate the probability of default of a given issuer. This data is then supplemented by the dealer's assumption about what the likely recovery rate will be in the event of a default, i.e. how far below par will the debt be trading when the company announces its default. Some models for determining the recovery rates in default use fixed percentages based on industry or credit ratings, while others rely on random, stochastic processes for default. These pricing models are good in that they are not overly data intensive and rely more on aggregate statistics. With regards to a new issuer, this model is good in that it does not require issuer-specific data sets. It does however limit one’s ability to introduce specifics about a particular issuer.

Credit-Spread Based Default Probability Models

These models track an issuer's credit spread over time and for differing maturities to establish a term-structure for their credit risk. Once this term structure is established, it is then used to estimate the probability of default of the issuer for a specific term. One of the advantages of this approach is that it allows for the use of issuer-specific data. Some weaknesses of this approach include the fact that a complete term structure of credit spreads for most issuers is not available, i.e. a company might have only three tranches of public debt of maturities of 2, 7 and 30 years. To use this data one must interpolate between these small number of points. Another assumption included in this model is that the entire spread over riskless assets is due to credit and does not consider market risk.

Pricing Based on Guaranteed Product Markets

Pricing based on guaranteed product markets is perhaps the simplest approach but is very limited in that it requires comparison to a credit default instrument already priced in the market. For example, if two counterparties have an agreement whereby one party is paying the other a margin of 100 basis points to guarantee the debt of a third party, then any similar default products on the third party should be priced similarly.

Replication/Cost-of-Funds Models

This model uses the hedging costs of a credit derivative as the basis for its pricing. Basically, the dealer decides – using probability models, default ratings or whatever he likes – what portfolio of assets he requires to hedge the payments under. In the example above, the dealer used a Total Return Swap. He next decides what kind of margin he requires on the TRS. The combination of the cost of constructing a hedge, along with the dealer's required return, establishes a price for the credit derivative. This is perhaps the most straightforward approach for cases when a hedge can be constructed and hedging or replication-pricing methods are common in all derivative areas. Problems arise, however, when a good hedge is not available or the costs associated with putting it together are too expensive.

4.2 Hedging Issues

The majority of credit derivatives outlined in this paper have themselves been the hedge to an existing exposure of the dealer, i.e. the TRS issued on a bank's existing loan portfolio serves as a reduction of the bank's risk and does not require hedging. What about stand alone trades where the dealer has no exposure to a particular area but is asked by a client to provide default protection against someone's receivables?

The main avenue available to credit derivatives dealers in these cases involve constructing replicating portfolios as best they can, using either the company's publicly traded bonds, equity or by opting for positions in a comparable company in the same industry. The techniques employed are comparable to the delta hedging of an options portfolio and require the dealer to make assumptions about the volatility (i.e. the probability of default) of the company being guaranteed. The dealer builds an offsetting portfolio whose positive return will mimic the loss incurred on the default protection in the event of default. Typical hedges involve shorting the companies bonds or equity. The particulars of an industry might allow a dealer to use a less-conventional hedge. For example, if the dealer suspects that the default of Lockheed on its bonds is a function of whether they win an upcoming contract on which they are bidding against Boeing and Airbus, the dealer might establish a small long position in Boeing stock as an additional hedge.

The hedging of credit derivatives, or any financial derivatives for that matter, is not an exact science. If the question, "How would you hedge the following default swap?" was posed to five credit derivative dealers, one would likely receive five slightly different answers.

5. Documentation and Regulatory Issues

5.1 Documentation

Due to the recent development of this market, there is a lack of standardized documentation and terminology for most credit derivatives. How to define a "credit event" can be cause for much debate when documenting a trade. In some cases, it has been defined as widening of the spread of the referenced credit from a benchmark by a certain number of points (i.e., 150 basis points over LIBOR) but other definitions are possible. How does one define the recovery value of an asset? Again various methods have been developed most of which include the conducting of a poll of the dealer prices for a predetermined period (e.g. two to three times per month for three months) until the value gravitates toward some mean price.

The focal point for all derivatives documentation is the International Swaps and Derivatives Association (ISDA) which is an industry trade group that collaborated on the first interest rate swap master agreement and has developed most of the standard documentation in the derivatives industry. ISDA has a task force that is developing standard documents for credit derivatives. In discussions with Chris Fowler of Chase Manhattan's Credit Derivatives desk, he stated that ISDA has recently completed a standard document for Total Return Swaps, which is being circulated for comments. They are also compiling a list of definitions and, among the completed set, is a standard definition of "credit event."

Based on the success ISDA has had in the interest rate, foreign exchange and commodity markets in establishing its documents as the basis for market growth, it seems likely that the credit derivatives market will benefit from the same type of documentation.

5.2 Regulatory Issues

The main regulatory hurdle, which is affecting the growth of the credit derivatives market, concerns the allocation of capital on a financial institution's balance sheet against outstanding credit derivatives contracts. Regulators set rules which define the amount of capital a firm must hold against its various risk positions. The amount of capital necessary for a given position is usually dependent on its relative risk. The firm needs more capital if the position is highly risky and less for higher quality assets. The Capital Adequacy Directive (CAD) of the European Union has defined various risk categories. Capital charges are made according to the risk categories of the position, including market risk, counterparty risk, large single party exposure and foreign exchange risk. A firm must have more capital than the sum of these and other charges due against all of its positions.

Credit derivatives pose problems both in terms of risk categorization as well as in netting of credit derivatives exposures against underlying loan portfolio exposures. They offer in many instances the possibility of offsetting counterparty risk against the market risk but may not achieve a reduction in risk capital requirements from the regulators. For example, a TRS may allow a credit exposure to be transformed into a market exposure plus some other counterparty exposure. The bank entering into the TRS against its existing loan position will be required under existing regulation to hold capital against both the loan and the offsetting credit swap, thus excluding any net benefit.

Various issues need to be sorted out, among them: Do default puts attract position risk charges? If yes, what are the appropriate risk weightings? What offsetting, if any, should be allowed for credit derivatives? What percentage of notional amounts must be held against different credit derivative transactions?

As was discussed above, there is still a lack of uniformity in the documentation of credit derivatives and the legal basis of many contracts remains unsupported by opinions. Given this situation, regulatory authorities are issuing capital treatment charges on an instrument by instrument basis. Given that capital charge treatments already exist for spread options and asset swaps, how the rules can be extended consistently to explicit credit derivatives is one of the questions facing the industry. Another question is when, if at all, regulators will recognize firms' internal models for credit derivative valuation. This problem is aggravated by the absence of widely accepted valuation techniques for credit derivatives.

Major market regulators including the Bank of England, The Bank for International Settlements and the Federal Reserve all have the credit derivatives market on their radar screens and will be issuing more specific guidelines as the market develops. For the moment, however, market participants are left with only a consultative paper from the Bank of England and Federal Reserve banking book guidelines for direction on capital allocation. There have been no formal statements made about the netting of capital requirements for portions of loan portfolios, which have been swapped out through derivatives. Perhaps the best summary of the state of regulatory affairs in the credit derivatives market is that it remains a work in progress. The only thing that is certain at this point is that Wall Street financial innovators wait patiently for new product ideas to come out of any changes in the regulatory framework.

6. Conclusion

Credit derivatives have many uses and provide flexibility to transfer and price credit risk more efficiently. The market has been estimated to cross $100 billion, but is growing throughout the world. The expected defaults in the Asian markets are expected to add to this growing market. Credit derivatives are likely to be used more extensively in those situations where buying or selling in cash markets is cumbersome and less efficient.

References

BZW, "An Investors’ Guide to Credit Derivatives," Derivatives Strategy (Credit Derivatives Supplement)(June 1997).

Irving, Richard, "Credit Notes in Recent Deals," Risk (September 1996).

Masters, Blythe, "A Credit Derivatives Primer," Derivatives Strategy (May 1996).

Murphy, David, "Keeping Credit Under Control," Risk (September 1996).

McDermott, Robert, "The Long-Awaited Arrival of Credit Derivatives," Derivatives Strategy (December 1996/January 1997).

Paul-Choudhury, Sumit, "Safe and Secure?" Risk (August 1996).

Nicholls, Mark, "Banking on a Compromise," Risk (Credit Risk Supplement) (July 1997).

Smithson, Charles (with Hal Holappa and Shaun Rai), "Class Notes: Credit Derivatives (2)," Risk (June 1996).

Spinner, Karen, "Building the Credit Derivatives Infrastructure," Derivatives Strategy (Credit Derivatives Supplement) (June 1997).

Styblo Beder, Tanya and Frank Iacono, "The Good, The Bad - and The Ugly?" Risk (Credit Risk Supplement) (July 1997).

Whittaker, J. Gregg and Wendy Li, "An Introduction to Credit Derivatives," Risk (Credit Risk Supplement) (July 1997).

ISDA web page provided information on the status of the Credit Derivatives Task Force

Informal discussions with the following professionals have contributed a great deal to this project:

Chase Manhattan Credit Derivatives Group

Gregg Whittaker, Vice President - Risk Management

Matt Fahey, Vice President - Risk Management

Chris Fowler, Vice President - Marketing

Joyce Frost, Vice President - Marketing

Bankers Trust

Phil Borg, Vice President, Credit Derivatives Group

Deutsche Morgan Grenfell

Seldon Sussman, Vice President, Credit Derivatives