Credit Derivatives Energy Finance and Credit Summit 2004 Risk Limited, Sungard and Deloitte (Sponsors) Four Seasons Hotel, Houston, Texas Friday, February

Credit Derivatives

Energy Finance and Credit Summit 2004

Risk Limited, Sungard and Deloitte (Sponsors)

Four Seasons Hotel, Houston, Texas

Friday, February 27, 2004

Leslie K. McNew

Clinical Professor, Finance and Director of the Trading Center

AB Freeman School of Business, Tulane University, New Orleans

504-865-5036

[email protected]

11

Growth in Credit Derivatives Market

British Bankers Association Survey Credit Derivatives (US $ Billions)

0

100

200

300

400

500

600

700

800

US

$ b

n

1996 2000199919981997

End 2001: $1.2 TrillionEnd 2002: $1.5 Trillion

22


Credit Derivatives

• Newest of the derivative markets

• Developed around 1992-1993

• Used to manage and exploit risks/opportunities in credit markets

• Risk transferred among participants----off or on balance sheet transactions

Off balance-sheet On balance-sheetCredit default swaps credit linked notestotal rate of return swaps CDO's (collateralised debt obligations)

33


London is the dominant financial center

• Size of the international debt market

• A market-friendly regulatory environment

• Liquid asset swap market

• Derivative strengths

44

Definitions

Credit Derivative: a credit derivative allows the holder to isolate andseparate credit risk from market risk, thusallowing this credit risk to be either hedged, traded, or transferred. A premium may be due.

Credit Default Swap: enables isolation and transfer of credit risk without transferring ownership of the asset

Digital Derivative: cash settled transaction (does not need delivery of underlying asset upon settlement)

Total Return Swap: transfer credit risk by swapping an underlying asset’sspecified total return (capital growth and interest) between two counterparties, in return for regular payments of LIBOR + spread

LIBOR: the London inter-bank offer rate. The inter-bank rate used when one bank borrows from another. It is also the benchmark used to price many capital market andderivative transactions.

Credit Spread: difference in ‘yields’ between an agreed reference rate and a specific asset in question.London: gilt marketUS: treasury market

Off-balance sheet: instrument or trade does not have to be admitted tothe firm’s balance sheet (can be ‘hidden’)

55

Credit Derivative ‘Trigger’ Events

• Payment default or bankruptcy/insolvency in the case of corporate credits• Moratorium on payments or the rescheduling of payments, as well as payment default itself, for sovereign credits• Chapter 11 or bankruptcy filing by the issuer• failure to meet payment obligations when due• rating downgrade below an agreed upon level• change in the agreed credit spread (over a government bond or compared to another government bond)

A materiality threshold (a significant price decline) has also to be breached and independently agreed.

66

Fee Determinants for Credit Derivatives

• credit rating or probable swap counterparty• maturity• probability of default• expected value of the asset (post-default)

assumed mark to market risk of per counterparty: $10,000,000

Porfolio SimulationName Ticker Ratings Industry 1 yr offer PricingDuke Energy Corp DUK A utility 82 $82,000American Electric Power AEP A utility 80 $80,000Sempra Energy SRE A utility 570 $570,000Reliant Energy Inc REI BBB utility 127 $127,000El Paso Electric Co EE BBB utility 136 $136,000Southern Co SO BBB utility 131 $131,000Dynergy Inc DYN BBB energy 126 $126,000 Value of Credit Unit Trust Today $1,252,000

Prices from around the time of the California energy crisis

Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005

77

Why Use Credit Derivatives? Protection Buyer

4 Main Reasons

1. Reduce exposure to a company or bank whose credit rating is deteriorating

2. To free up credit lines so that higher margin businesses may be transacted

3. To protect against a downgrading below a portfolio manager’s internal limits

4. To reduce credit exposures which have exceeded limits, possibly where interest rates or currency movements have exceeded expectations

1010

Credit Default Swap: in Energy Market

Energy Company

InvestmentBank

Receive $ notional amount of credit protection

assumed mark to market risk of per counterparty: $10,000,000Porfolio SimulationName Ticker Ratings Industry 1 yr offer PricingDuke Energy Corp DUK A utility 82 $82,000

Energy Company pays 82 basis points to receive, within 1 year, $10 M from the Investment Bank if Duke Energy defaults

$

If Duke defaults within one year, the Energy company owns default ‘insurance’ that will pay $10 M regardless of the amount of the Duke default

• Energy Company has a large exposure to Duke due to trading activities• Energy Company wishes to reduce default risk to Duke• Energy Company buys credit derivative from Investment Bank to reduce (‘insure’) Duke credit risk exposure: purchases a DITIGAL instrument• Investment Bank only pays out notional amount to Energy Company if Duke experiences a default event (see “Triggers”)

1111

Total Return Swap

Instead of lump sum notional payment in the event of default, the protection buyer receives a specified economic value for the reference credit.

Total Return Payer (X) Total Return Receiver (Y)Total Return of Asset

LIBOR + spread

Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protectionTotal Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protectionReference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure

• Energy Company (X) pays any appreciation on the capital value of the underlying asset as well as any coupons receivable• Investment Bank (Y) pays Energy Company (X) any depreciation of the capital value as well as a LIBOR linked floating margin• Energy Company (X) is guaranteed a specified capital value for the underlying, as well as a LIBOR linked income for the duration of the swap• Investment Bank (Y) ‘owns’ the credit risk, as well as any income and any profits generated by this asset• Energy Company (X) retains the ownership of the reference asset, and must continue to fund the asset (reference asset)• If there is no credit event, there will be no contingent payment

Reference Asset

1212

Total Return Swap

Total Return Payer is the Energy Company (X) --- seller of risk, buyer of protectionTotal Return Receiver is the Investment Bank (Y) – buyer of risk, seller of protectionReference Asset could be bond of another energy company that Energy Company (X) has credit risk exposure

Why Use Total Return Swaps?• lock in a specified economic value for the duration of the swap• transfer the market risk of an asset off-balance sheet to lower regulatory charges• used for trading credits on a leverage off-balance sheet basis

Total Return Payer (X) Total Return Receiver (Y)Total Return of Asset

LIBOR + spreadReference Asset

1313

Credit Spreads

Credit Spread: difference in ‘yields’ between an agreed reference

rate and a specific asset in question.

London: gilt market

US: treasury market

Example:T0 Corporate bond trades at 55 basis points over gilt

T1 Corporate bond now trades at 45 basis points over gilt• the credit spread has ‘narrowed’ (‘tightened’)• credit quality of bond/bond issuer has improved

WIDER CREDIT SPREADS IMPLY MORE LIKELY CHANCE OF DEFAULT

1414

Credit Spreads

2 Distinct Versions:Credit spread relative to benchmarkCredit spread between two ‘credit-sensitive’ assets

Easiest way to enter transaction is through OPTIONS

Credit spread options enable trading/hedging of changes in credit quality of the specified reference credit

Strike set at a particular credit spread

1515

Credit Spread Options

Payoff:Payoff:C[spread(T);(K)] = (spread(T) – K) x notional amount x risk factorC[spread(T);(K)] = (spread(T) – K) x notional amount x risk factor

WhereWhereSpread(T) =Spread(T) = the spread for the financial asset over the risk-less rate at the the spread for the financial asset over the risk-less rate at the

maturity of the optionmaturity of the optionK =K = the specified strike spread the specified strike spread

Notional amount =Notional amount = a contractually specified dollar amount equal to the amounta contractually specified dollar amount equal to the amountthat needs to be hedgedthat needs to be hedged

Risk Factor =Risk Factor = based on measures of duration and convexitybased on measures of duration and convexity

For a description of duration, convexity and other financial calculations, purchaseFor a description of duration, convexity and other financial calculations, purchase‘‘Mastering Financial Calculations,’ Robert Steiner, Financial Times/Pitman Publishing,Mastering Financial Calculations,’ Robert Steiner, Financial Times/Pitman Publishing,1998, refer to chapter 5 for bond market calculations, and chapter 9 for options1998, refer to chapter 5 for bond market calculations, and chapter 9 for options

1616


INPUTSnotional $1,000current spread 150strike 150duration 1 yearrisk factor 1.867current credit rating A

PROTECT AGAINST A CREDIT DOWNGRADE FROM 'A' TO 'B'PROTECT AGAINST CREDIT SPREAD WIDENING --- POTENTIAL FOR DEFAULT INCREASING

1. Energy Company X is concerned about a ‘credit downgrade’ of one of its counterparties2. Current counterparty is trading “A” rating, Energy Company X is concerned it will be

downgraded to a “B”3. Energy Company X buys ‘downgrade’ protection in the form of a credit spread option4. If the credit spread on its counterparties widens, downgrade from “A” to “B”, Energy

Company X receives a payout5. Energy Company X buys a call option on the credit spread (widening spread) and pays a

premium

In basis pointsIn basis points

Basis point conversion to decimal: example, 50 bps = 50/10,000 = .005

1717


Payout Profile of a Credit Migration Downward Option

-$20.00

-$8.00

$4.00

$16.00

$28.00

$40.00

$52.00

$64.00

$76.00

op

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Payment of premium

Breakeven Credit spread has widened from 150 bps to 300 bps after 1 year, and option pays out

Option payout = change in credit spread x notional amount x risk factorOption payout = [(300-150)/10,000] x $1,000 x 1.867 = $28.00

Just as a portfolio manager may purchase protection on a single name (credit), said manager may also purchase protection on a basket of names (credits): two or more.

In the case of the FIRST TO DEFAULT STRUCTURE, the credits in the ‘basket’ are protected against default for a set notional amount. The risk credit to default triggers the basket payout and basket termination. At this point, the other credits are left un-hedged, and most be re-hedged.

Duke Energy CorpAmerican Electric PowerSempra Energy Reliant Energy IncEl Paso Electric CoSouthern CoDynegy Inc

$10 M Notional Total

FIRST TO DEFAULT BASKET

Energy Company X

InvestmentBank

$

NexCollateral receives $10 M if ONE of the basket’s participants defaults

FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance1818

First to Default Basket Options: Notional Payout

outright credit default derivatives assumed mark to market risk of per counterparty: $10,000,000Porfolio SimulationName Ticker Ratings Industry 1 yr offer PricingDuke Energy Corp DUK A utility 82 $82,000American Electric Power AEP A utility 80 $80,000Sempra Energy SRE A utility 570 $570,000Reliant Energy Inc REI BBB utility 127 $127,000El Paso Electric Co EE BBB utility 136 $136,000Southern Co SO BBB utility 131 $131,000Dynergy Inc DYN BBB energy 126 $126,000 Value of Credit Unit Trust Today $1,252,000

Credit Default Option on Basket assumed mark to market risk of per counterparty: $10,000,000Porfolio SimulationName Ticker Ratings Industry 1 yr offer PricingDuke Energy Corp DUK A utilityAmerican Electric Power AEP A utilitySempra Energy SRE A utilityReliant Energy Inc REI BBB utilityEl Paso Electric Co EE BBB utilitySouthern Co SO BBB utilityDynergy Inc DYN BBB energy Basket Cost 457 Value of Credit Unit Trust Today $457,000

Cost Savings by Using Default Basket $795,000COST SAVINGS

FIRST TO DEFAULT BASKETS are generally suited for investment-grade credits with low correlations and low covariance

First to Default Baskets vs. Straight Credit Default Derivatives

1919

2020

APPENDIX E - CREDIT RISK LIMITS

Table 1: Portfolio Mix Limits, secured by parental guarantees

Maximum % of

Outstanding Exposure**Rating Max. Tenor By Rating CategoryAAA 3 years N/AAA 3 Years N/AA 3 Years 50%BBB (1)2 Years 30%

Actual Policy of Midwestern Utility

Collateral (security) comes in different formats: Cash Securities Treasuries Surety Bonds Letters of Credit Parental Guarantees

Can be converted to cash in case of default

Promise made on behalf of parent to secure activity undertaken by subsidiary, to a specific entity (contractual form). At current time, promise only secures the pre settlement and settlement risk of actual transactions, no VaR or liquidated damages. Specific entity usually must seek legal recourse to recover against this form of collateral in the case of default.

In Energy industry, large percentage of trading partners rated BBB or less, and the convention is to secure transactions with parental guarantees

PRACTICAL EXAMPLES

2121

Apply Credit Derivatives to Policy Objectives



Maximum % of



Problem:1. Corporate does not want to have significant portfolio exposure to BBB risk2. Corporate does not want to have significant portfolio exposure to parental guarantees as security3. Energy industry, as practice, transacts on parental guarantees4. Energy industry participants heavily weighted toward BBB5. Need large liquid pool from which to transact to make $$$$

PRACTICAL EXAMPLES

2222




Maximum % of



Answer:Secure all BBB parental guarantee participants beyond 30%threshold with credit derivatives

Mitigate the portfolio credit risk by buying protection

Name Ticker Ratings Industry 1 yr offer PricingReliant Energy Inc REI BBB utility 127 $127,000El Paso Electric Co EE BBB utility 136 $136,000Southern Co SO BBB utility 131 $131,000Dynergy Inc DYN BBB energy 126 $126,000

PRACTICAL EXAMPLES

2323

Credit ReportCredit Month A/R Available

Counterparty Symbol Rating Limit Prior Current MTM VaR CreditReliant REI BBB $15,000,000 $3,120,000 $227,868 $7,869,873 $2,298,429 $1,483,830

Credit Hedge ReportCredit Derivative Portfolio Credit

Counterparty Symbol Rating Limit Notional bps cost ExposureReliant REI BBB $15,000,000 $15,000,000 127 $190,500 $0


Individual Counterparty Hedge:1. Set traditional credit limit2. Purchase protection in form of default credit derivative against credit limit

(limit and notional amount must match)3. Mitigate all credit exposure to counterparty by above off-balance sheet

transaction (transferred risk to AA rated investment bank --- always risk that said bank will default)

4. Monitor available credit such that it does not exceed credit limit5. Charge traders or profit center for cost of credit derivative6. 100% compliance with policy while still allowing trading liquidity

PRACTICAL EXAMPLES

2424

Counterparties Over Credit LimitPRACTICAL EXAMPLES

Credit Month A/R AvailableCounterparty Symbol Rating Limit Prior Current MTM VaR CreditReliant REI BBB $10,000,000 $3,120,000 $227,868 $7,869,873 $2,298,429 -$3,516,170

Problem/Resolution:1. Traders/marketers put deal in system that breaches credit limits2. Discipline action required (see policy)3. Company now exposed to greater risk than desired4. Purchase default derivative to cover risk until situation can be resolved5. Charge person/group responsible for cost of protection (against their P/L)

Credit Hedge ReportAvailable Derivative Available

Counterparty Symbol Rating Credit Notional bps cost CreditReliant REI BBB -$3,516,170 $5,000,000 127 $63,500 $1,483,830

2525

Credit in High Volatility Months

Power Forward Price Curve

$0$20$40$60$80

$100$120$140$160

Feb-99

Mar-99

Apr-99

May-99

Jun-99

Jul-99

Aug-99

Sep-99

Oct-99

Nov-99

Dec-99

Jan-00

Feb-00

5.3.5. Period of High Volume and Extreme Price Volatility. Periods of Extreme Price Volatility and/or Peak Volumes At certain times during the year the company may enter periods of high transaction volume and/or extreme price volatility. These circumstances may cause a significant percentage of the company’s counterparties to exceed their credit limit. From a business standpoint, it is not practical to cease all trading with such counterparties during periods such as these, thus significantly limiting trading options and liquidity. If the Vice President of Risk Management, the Senior Management, and the Risk Management Steering Committee determines that the company is in such a period, they may instruct the Director of Credit to implement credit limit overrides based upon the following guidelines:

% of Credit Limit $$ Limit of Rating Override Override

AAA 25% $ 5 million AA 25% $ 4 million A 20% $ 3 million BBB 20% $ 1 million

PRACTICAL EXAMPLES

Example, summer is high volatilityfor power. Keep the deals on the book,get paid for the extra risk that thecompany is taking.

2626

PRACTICAL EXAMPLESCredit in High Volatility Months

Energy Company (X) Investment Bank (Y)Total Return of Asset

LIBOR + spreadDynegy

Total Return Swap

lock in a specified economic value for the duration of the swap

1. Energy Company X will raise credit limits during high vol months

2. Energy Company X takes on more risk during this period and wishes to be compensated for said risk

3. Total return swap pays Energy Company X a rate equal to LIBOR + spread, and any depreciation on asset (Dynegy)

4. Energy Company X pays investment bank any appreciation on asset (Dynegy)

5. Energy Company X earns a higher rate of return during the swap, which compensates it for the increased risk that it is assuming

2727

PRACTICAL EXAMPLES

Problem1. Rumors in energy industry indicate that problems are brewing

in California market (possibility of credit defaults)2. Energy company X has large position due to trading

transactions with PG&E3. Energy company X wants a credit hedge to offset against any

cash flow problems PG&E may incur (credit manager is hearing rumors, and wants some protection, but not costly protection

4. Energy company X credit manager buys credit spread call (credit widening---possibility of default greater), struck at current spread level, on PG&E

5. Energy company X credit manager buys call against current mark to market position (notional amount of call equals current mark to market credit risk position with PG&E)

Payout of PG&E Credit Migration Downward Credit Spread Option

$0.00

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

$1,400,000.00

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2828

Credit Spreads Against Credit Migration DownwardPRACTICAL EXAMPLES

Payment of premium

Breakeven Credit spread has widened from 72 bps to 600 bps after 6 months, and Energy Company X gets out of option

Current credit spread is 72 bps., and credit manager sets notional amount at $10 M. Credit spread widens to 600 bps after 6 months, and the option pays out over $3 M. If the credit manager had been wrong on acting on the rumor, the cost of the option would have been minimal. As it was, the credit manager acted, and although PG&E did not default, the spread widen to compensate the credit manager for the extra risk her portfolio had taken to transact with PG&E

2929

Optimal Credit Protection Column

Credit Portfolio Insurance

Letters of Credit

Credit Derivatives

Parental Guarantees

All of payoff in event of default situation

Payoff based on recovery percentage

Example of a List of Corporate Bonds

Type in stock ticker (AEP)After stock ticker, space, type “CORP”GOSelect Corporate Bond desired for analysis

3030

Using Bloomberg

corporation

Select Corporate BondThen, when inside bond, ASW GO

Good way to get an estimation, actual quotes differ by 20-50 bps.3131

Using Bloomberg

American Electric Power Basis Spread (5-Year Bond)

0

20

40

60

80

100

120

140

160

5/4/

2001

5/14

/200

1

5/22

/200

1

5/30

/200

1

6/8/

2001

6/19

/200

1

6/28

/200

1

7/6/

2001

7/16

/200

1

7/24

/200

1

8/1/

2001

8/9/

2001

8/20

/200

1

8/28

/200

1

9/5/

2001

9/13

/200

1

9/26

/200

1

10/5

/200

1

10/1

5/20

01

10/2

4/20

01

11/1

/200

1

11/9

/200

1

11/1

9/20

01

11/2

7/20

01

12/6

/200

1

12/1

4/20

01

12/2

4/20

01

1/1/

2002

1/9/

2002

1/17

/200

2

1/25

/200

2

2/4/

2002

2/12

/200

2

2/20

/200

2

Date

Bas

is P

oin

ts

3232

Using Bloomberg

Documents

Credit Derivatives Energy Finance and Credit Summit 2004 Risk Limited, Sungard and Deloitte (Sponsors) Four Seasons Hotel, Houston, Texas Friday, February