Understanding Credit Derivatives and Related Instruments Understanding Credit Derivatives and Related Instruments Second Edition Antulio N Bomfim AMSTERDAM • BOSTON • HEIDELBERG • LONDON NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Academic Press is an imprint of Elsevier Academic Press is an imprint of Elsevier 225 Wyman Street, Waltham, MA 02451, USA The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK Copyright © 2016 Elsevier Inc All rights reserved No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher Details on how to seek permission, further information about the Publisher’s permissions policies and our arrangements with organizations such as the Copyright Clearance Center and the Copyright Licensing Agency, can be found at our website: 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operation of any methods, products,instructions, or ideas contained in the material herein Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-12-800116-5 For information on all Academic Press publications visit our web site at http://store.elsevier.com/ Typeset by Spi Global, India Printed in USA Dedication To Kimberly, Sarah, Emma, and Eric Author’s Disclaimer The analysis and conclusions set forth herein are my own, and I am solely responsible for its content vii Preface to the Second Edition Much has changed in the global credit derivatives market since the publication of the first edition of this book For one, we have lived through the 2008 financial crisis, the most significant period of financial market turmoil since the Great Depression In addition, the credit derivatives market itself—which was still quite young when the first edition was published—has since evolved in ways that are not necessarily linked to the crisis Some of the new topics discussed in this new edition reflect (directly or indirectly) developments precipitated by the 2008 crisis For instance, in a substantially rewritten Chapter 2, I discuss the evolution of the market in recent years, documenting stark differences in key market characteristics in the pre- and post-crisis periods, such as the much reduced prevalence of synthetic collateralized debt obligations since the crisis and the growing role of central counterparties The crisis has also brought about important changes in the regulatory framework facing market participants I highlight some of these changes in a revised chapter on regulatory issues But this is not a book about the financial crisis My goal remains to offer a comprehensive introduction to credit derivatives and related instruments The book’s focus still is to provide intuitive and rigorous summaries of major topics, including a discussion of different valuation tools and their relation to various credit modeling approaches With that in mind, I have updated the discussion in most chapters to keep it consistent with current market trends For instance, since the publication of the first edition, standardized coupons and upfront payments have become the norm in the global credit derivatives market This topic is addressed throughout the book, which now includes a mathematical framework for valuing upfront payments Lastly, this second edition includes five brand new chapters Chapters 15 and 16 address credit default swap (CDS) indexes and CDS written on commercial mortgages (CDS/CMBS) and subprime residential mortgages (CDS/ABS) These structures barely existed when I was writing the first edition of this book Yet, CDS indexes have since become a key part of the global credit derivatives market While the same cannot be said about CDS/CMBS and CDS/ABS, they were an important part of the market at the time of the 2008 financial crisis and were the focus of much attention back then xix xx Preface to the Second Edition The remaining three brand new chapters included in this second edition are all in Part VI of this book, where I address issues related to the hedging and trading of CDS positions To provide additional intuition and make the discussion in that part of the book more concrete, the discussion is enriched with several detailed numerical examples Antulio N Bomfim Chapter Credit Derivatives: A Brief Overview Chapter Outline 1.1 What Are Credit Derivatives? 1.2 Potential “Gains from Trade” 1.3 Types of Credit Derivatives 1.3.1 Single-Name Instruments 1.3.2 Multiname Instruments 1.3.3 Credit-Linked Notes 1.3.4 Sovereign vs Other Reference Entities 1.4 Valuation Principles 1.4.1 Fundamental Factors 5 9 1.4.2 Other Potential Risk Factors 1.4.2.1 Legal Risk 1.4.2.2 Model Risk 1.4.3 Static Replication vs Modeling 1.4.4 A Note on Supply, Demand, and Market Frictions 1.5 Counterparty Credit Risk (Again) 10 10 11 12 13 14 In this chapter, we discuss some basic concepts regarding credit derivatives We start with a simple definition of what is a credit derivative and then introduce the main types of credit derivatives Some key valuation principles are also highlighted 1.1 WHAT ARE CREDIT DERIVATIVES? Most debt instruments, such as loans extended by banks or corporate bonds held by investors, can be thought of as baskets that could potentially involve several types of risk For instance, a corporate note that promises to make periodic payments based on a fixed interest rate exposes its holders to interest rate risk This is the risk that market interest rates will change during the term of the note In particular, if market interest rates increase, the fixed rate written into the note makes it a less appealing investment in the new interest rate environment Holders of that note are also exposed to credit risk, or the risk that the note issuer may default on its obligations There are other types of risk associated with debt instruments, such as liquidity risk, or the risk that one may not be able to sell or buy a given instrument without adversely affecting its price, and prepayment risk, or the risk that investors may be repaid earlier than anticipated and be forced to forego future interest rate payments Understanding Credit Derivatives and Related Instruments http://dx.doi.org/10.1016/B978-0-12-800116-5.00001-5 Copyright © 2016 Elsevier Inc All rights reserved PART I Credit Derivatives: Definition, Market, Uses Naturally, market forces generally work so that lenders/investors are compensated for taking on all these risks, but it is also true that investors have varying degrees of tolerance for different types of risk For example, a given bank may feel comfortable with the liquidity and interest rate risk associated with a fixed-rate loan made to XYZ Corp., a hypothetical corporation, especially if it is planning to hold on to the loan, but it may be nervous about the credit risk embedded in the loan Alternatively, an investment firm might want some exposure to the credit risk associated with XYZ Corp., but it does not want to have to bother with the interest risk inherent in XYZ’s fixed-rate liabilities Clearly, both the bank and the investor stand to gain from a relatively simple transaction that allows the bank to transfer at least some of the credit risk associated with XYZ Corp to the investor In the end, they would each be exposed to the types of risks that they feel comfortable with, without having to take on, in the process, unwanted risk exposures As simple as the above example is, it provides a powerful rationale for the existence of the expanding market for credit derivatives Indeed, credit derivatives are financial contracts that allow the transfer of credit risk from one market participant to another, potentially facilitating greater efficiency in the pricing and distribution of credit risk among financial market participants Let us carry on with the above example Suppose the bank enters into a contract with the investment firm whereby it will make periodic payments to the firm in exchange for a lump sum payment in the event of default by XYZ Corp during the term of the contract As a result of entering into such a contract, the bank has effectively transferred at least a portion of the risk associated with default by XYZ Corp to the investment firm (The bank will be paid a lump sum if XYZ defaults.) In return, the investment company gets the desired exposure to XYZ credit risk, and the stream of payments that it will receive from the bank represents compensation for bearing such a risk The basic features of the financial contract just described are the main characteristics of one of the most prevalent types of credit derivatives, the credit default swap In the parlance of the credit derivatives market, the bank in the above example is typically referred to as the buyer of protection, the investment firm is known as the protection seller, and XYZ Corp is called the reference entity.1 1.2 POTENTIAL “GAINS FROM TRADE” The previous section illustrated one potential gain from trade associated with credit derivatives In particular, credit derivatives are an important financial The contract may be written either to cover default-related losses associated with a specific debt instrument of the reference entity or it may be intended to cover defaults by a range of debt instruments issued by that entity, provided those instruments meet certain criteria, which may be related to the level of seniority in the capital structure of the reference entity and to the currency in which the instruments are denominated Credit Derivatives: A Brief Overview Chapter | engineering tool that facilitates the unbundling of the various types of risk embedded, say, in a fixed-rate corporate bond As a result, these derivatives help investors better align their actual and desired risk exposures Other related potential benefits associated with credit derivatives include:2 ● ● ● Increased credit market liquidity: Credit derivatives potentially give market participants the ability to trade risks that were previously virtually untradeable because of poor liquidity For instance, a repo market for corporate bonds is, at best, illiquid even in the most advanced economies Nonetheless, buying protection in a credit derivative contract essentially allows one to engineer financially a short position in a bond issued by the entity referenced in the contract Another example regards the role of credit-linked notes, discussed in Chapter 12, which greatly facilitate the trading of bank loan risk Potentially lower transaction costs: One credit derivative transaction can often stand in for two or more cash market transactions For instance, rather than buying a fixed-rate corporate note and shorting a government note, one might obtain the desired credit spread exposure by selling protection in the credit derivatives market.3 Addressing inefficiencies related to regulatory barriers: This topic is particularly relevant for banks As will be discussed later in this book, banks have historically used credit derivatives to help bring their regulatory capital requirements closer in line with their economic capital.4 1.3 TYPES OF CREDIT DERIVATIVES Credit derivatives come in many shapes and sizes, and there are many ways of grouping them into different categories The discussion that follows focuses on three dimensions: single-name vs multiname credit derivatives, funded vs unfunded credit derivatives instruments, and contracts written on corporate reference entities vs contracts written on sovereign reference entities 1.3.1 Single-Name Instruments Single-name credit derivatives are those that involve protection against default by a single reference entity, such as the simple contract outlined in Section 1.1 We shall analyze them in greater detail later in this book In this chapter, we These and other applications of credit derivatives are discussed further in Chapters and 3 An important caveat applies Obviously, whether or not the single transaction actually results in lower costs to the investor than the two combined transactions ultimately depends on the relative liquidity of the cash and derivatives markets The notions of regulatory and economic capital are discussed in greater detail in Chapters and 27 .. .Understanding Credit Derivatives and Related Instruments Second Edition Antulio N Bomfim AMSTERDAM • BOSTON • HEIDELBERG • LONDON... price, and prepayment risk, or the risk that investors may be repaid earlier than anticipated and be forced to forego future interest rate payments Understanding Credit Derivatives and Related Instruments. .. countries Understanding Credit Derivatives and Related Instruments http://dx.doi.org/10.1016/B978-0-12-800116-5.00002-7 Copyright © 2016 Elsevier Inc All rights reserved 17 18 PART I Credit Derivatives: