Business F723

Fixed Income Analysis

Week 12

Credit Derivatives and Review

2

Credit Derivatives

• Similar to the way interest rate derivatives allow the transfer of some of the interest rate risk, credit derivatives allow an investor to transfer credit risk to others

• These derivatives are often more efficient to use than actual cash market postions

3

Types of Credit Risk

• Default risk– the issuer of the security fails to make the

promised payments

• Credit spread risk– due to a credit upgrade or downgrade, the

required yield spread over treasury changes, affecting the price of the bond

4

ISDA

• International Swap and Derivatives Association

• Since 1998 has set standard contracts for credit default swaps and total return swaps

• The contracts are flexible enough to use for the other derivatives listed

5

References

• The contracts are based on some underlying security, referred to as:– reference entity or reference issuer; the firm

that issued the bond and who’s credit risk is being transferred

– reference obligation or reference asset; the particular bond issue (or other debt instrument) that is being protected

6

Credit Events

• Many of the derivatives pay off when a particular event happens– Bankruptcy– Failure to pay– Obligation acceleration; the firm violates a term

in the covenant making the bond due & payable– Repudiation/moratorium; rejecting the above– Restructuring; controversial, see next slide

7

Restructuring

• Prior to seeking bankruptcy protection, a debtor can make a proposal to creditors or seek a restructuring of their debt

• Problematic due to the discretion of the holders of the debt to accept the proposal

• IDSA form has 4 different methods of handling restructuring in the contract– none, all, modified and modified modified

8

Asset Swap

• Not strictly a credit derivative since credit risk is not traded– Own a bond paying fixed coupons, enter a swap

agreement to trade fixed for floating payments– Sell the asset to a dealer with a swap agreement

and an obligation to buy back the bond if there is a credit event

9

Total Return Swap

• A swap agreement where one party makes floating rate payments and the counter party makes payments based on the total return (interest and capital gain/loss) of the reference obligation

• Cash flow of the total return payer is similar to short selling the reference obligation and investing the proceeds

10

Credit Default Swap

• Buyer pays a premium (a % of the notional amount), on a quarterly basis, to protect against default

• In the event of a credit event, the seller of the swap buys the underlying asset from the buyer for the notional amount

• Can be based on a basket of assets

11

Credit Spread Options

• Underlying is a reference obligation– a call or put option where the strike price is not

fixed but based on a fixed spread over treasury

• Underlying is the credit spread– a cash settlement contract where the payoff is

based on the difference between the reference obligation’s credit spread vs. the strike spreadx notional amount x risk factor

12

Credit Spread Forwards

• Similar to the difference between forward contracts and option contracts on any other commodity

• Related to a credit spread option, but the final settlement is not based on one party having the choice to exercise, so no option premium is required

13

Structured Credit Products

• Debt instruments with payoffs linked to the credit performance of reference obligations

• Synthetic CDO: Invests in low risk assets and sells credit protection derivatives– Dominates the CDO market

• Credit-linked notes: short term debt, 1 - 3 years; if the reference asset defaults the note is paid off early and at a discount

14

Rapid Review

15

Call Protection

• Most commercial mortgages do not allow free prepayments– Prepayment lockout– Defeasance– Prepayment penalty points– Yield maintenance charges

16

Balloons

• Commercial mortgages typically have a balloon maturity provision

• Lender may allow an extension if the borrower has difficulty refinancing, but charge a higher default interest rate– The possibility of default on the balloon

payment is called balloon risk and, with the above provision can be a form of extension risk

17

Services

• Can have a single servicer or multiple– Sub-servicer; collects cash and information– Master servicer; oversees the deal, verifies

details of the agreement, makes timely payment of interest and principal (even when there are late payments)

– Special servicer; deals with accounts more than 60 days overdue

18

Credit Enhancement

• As with MBS, asset backed securities often include credit enhancement to get the credit rating the issuer desires– External enhancement; insurance, corporate

guarantees, letters of credit– Internal enhancement; reserve funds, over-

collateralization, senior/subordinated structure

19

Static Spread

• Find the treasury spot rate term structure using the bootstrapping method

• Find the present value of the cash flows for the bond using the spot rate plus a spread

• Solve for the spread that gives the current price

• Called the static or zero volatility spread

20

Negative Convexity

• The normal price/yield curve is convex

• With price compression the level of convexity can become negative (technically it is now concave)

• Price change from increasing interest rates becomes larger than the change from falling interest rates

21

Interest Rate Volatility

• The major influence on the price of a bond is interest rates

• Changes in interest rates can be measured over time and the volatility can be estimated

• Can be used to create an interest rate model

• Textbook model is single factor, lognormal random walk, binomial interest ladder or lattice, estimating potential forward rates

22

Convertible Bonds

• Another type of embedded option

• A call option on a number of the issuer’s common share where the exercise price is the bond, regardless of current market value

• Number of shares is conversion ratio

• Can be physical or cash settle

• Exchangeable bonds are similar options, but on other company’s shares

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Minimum Price

• The bond will trade at a minimum of the greater of the conversion value or straight (debt) value– conversion value: how much the stock that the

bond can be converted to is worth– straight value: the value of the convertible if it

did not have the conversion option

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Market Conversion Prices

• Since the exercise price is the bond, the effective price of the common stock changes over time

Mark et price of bondConversion ratio

Conversion premium per shareMark et price of common stock

Mark et conversion price

=

Mark et conversion premium per share

= Mark et conversion price -Current

mark et Price

Mark et conversion premium ratio

=

25

Jargon

• A convertible where the option is well out of the money is called a bond equivalent or busted convertible

• A convertible with a conversion value much higher than its straight value is called an equity equivalent

• Between those it is a hybrid security

26

Options Approach

• Similar to callable bonds, convertibles can be viewed as a bond and an option

• An additional problem here is that the exercise price on the share changes over time as the bond’s market price is affected by changes in interest rates

• To make matters worse, most convertible bonds are also callable

27

Futures

• Similar to a forward contract in the fact that it binds both parties to a specific transaction in the future… but– A futures contract is standardized with respect

to the quantity, quality, time, and location– Contracts are traded on organized exchanges– No specific link between the buyer and seller– Gains or losses are realized on a daily basis

28

T-Bill Quotes

• T-bills are quoted on the annualized yield on a bank discount basis

360

360

tFYD

tF

DY

d

d

maturity toDays

valueFace

discountDollar

decimal a as yield Annual

t

F

D

Yd

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T-Bill Futures Prices

• Quoted on an index basisindex price = 100 - (Yd x 100)

• Given a current quote of 3.75% for T-bills index price = 100 - (3.75) = $96.25

• Given a futures price of $92.50 the yield is

%5.7075.0100

50.92100

100

priceindex 100

dY

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Invoice Price

• This is how much is paid for the t-bill if it is delivered

• Invoice price = $1,000,000 - D

• Find the invoice price if the final settlement price is $92.50

67.041,981000,000,1$

33.958,18$360

91000,000,1$075.0

DInvoice

D

31

Treasury Bond Futures Details

• Price quoted per $100 of face value

• Price quoted in $1/3296-13 means $(96 + 13/32) = $96.40625

• Invoice price = Contract size (face value/100)

x settlement price x conversion factor + accrued interest

32

1Cost

Invoice 365

t

Cheapest to Deliver

• Given a choice sellers will want to figure out which issue is the cheapest to deliver

• Face value of issue is set at $100,000 but actual price is affected by conversion ratio

• Find implied repo rate

• Highest repo rate is the cheapest to deliver

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Theoretical Price

• Assuming short sales, we can also do the reverse, so we can get a theoretical price

• profit = 0 = proceeds - outlay• F = P(1 + t(r - c))

F = futures price P = Current bond pricet = time to deliveryr = financing costc = current yield on underlying bond

• (r - c) called cost of carry

34

Option Basics

• Options are based on buying or selling an asset in the future at a fixed price

• This transaction is not guaranteed to take place

• With an option one party to the option decides whether or not the transaction will be completed on the specified date

35

Option Basics

• The option has given one party the right but not an obligation to buy or sell the asset at the fixed price

• As you might guess, this party has to pay the other party for this privilege

• The payment is called the option premium

36

Call Option Price

Exercise Price

MarketPrice

Value

option price

intrinsic value

37

Futures Options

• The right to enter into a futures contract at a pre-specified price

• Call option: the right to take a long position

• Put option: the right to take a short position

• If exercised, the futures contract is written at the specified price, and immediately marked to market by the exchange

38

Interest Rate Swaps

• Main idea is to trade fixed rate interest payments (receipts) for floating rate payments (receipts)

• Swaps have counterparty risks since they are not traded on organized exchanges

• May involve a securities firm or commercial bank as a broker or dealer

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Interpreting a Swap

• There are 2 ways of looking at a swap

• A package of forward contracts

• A package of cash market instruments– Buy a 9% fixed coupon $50m bond– Finance by borrowing $50 at LIBOR

40

Beyond Plain Vanilla

• Varying principal swaps: the principal on which interest is calculated changes over time… often for amortizing securities

• Basis swaps: exchanging floating rate payments based on different reference rates– Constant Maturity Swap: one of the reference

rates is the constant maturity treasury (CMT) rate published by the federal reserve

41

Beyond Plain Vanilla

• Swaptions: an option to enter into a swap contract at a point in the future

• Forward start swap: a swap contract were the start date of the swap is in the future

42

Caps and Floors

• Interest rate agreements include– The reference rate– The strike rate (cap or floor)– The length of the agreement– The frequency of settlement– The notional principal