Abstract
Almost all of the
financial instrument are inherent with credit risk, which is exposed if the
borrower is unable to meet the financial obligation on time. To minimize such
credit risk financial institution go thoroughly to the credit worthiness of the
borrower, which is a traditional way to minimize the potential risk by avoiding
it. The modern evolution of financial market have developed sophisticated
instrument and techniques to minimize credit risk. One of them is credit
derivative, these instrument helps to segregate the credit risk from the
underlying assets and makes the credit risk tradeable. The first part of the
article is focused on the introduction, development and advantage of credit
derivative. The second part analyze the various types of credit derivative
instrument as modern technique for managing potential credit risk. Finally some
of the risk associated with the credit derivative instrument have been analyzed
on the third part to give the basic outlook on the various instrument of
sophisticated credit risk management instrument of advance Derivative and
Commodities market.
Keyword: Credit
Risk, Credit Derivative, Credit Default Swap, Total Return Swap, Assets Swap,
Credit Linked Note
Introduction
Credit
Derivative indicates the instrument or technique that helps to separate and
transfer one of the major risk of traditional finance; that is credit risk.
Credit risk is associated with the obligation, it arises when the
pre-determined obligation with financial instrument is not fulfilled on time.
This indicates the counter party default on promised obligation. Derivative
products or Instrument created on this credit risk is credit derivative
product, they were first purposed in 1992 at Conference of International Swap
and Derivative Association (ISAD). A credit derivative consist privately held
negotiable contract that allows users to manage their exposure to credit risk
related to an underlying entity from one party to another without the actual
transference of underlying entity. Credit derivative also enables stripping the
credit risk of a security from its other risk. Credit derivative are the over
the counter (OTC) product and hence can be tailored to the user specification.
Application
and Advantage of Credit Derivative Products
As
mentioned in the introduction part that the credit derivative is mainly used to
segregate and minimize the credit risk. This enables the lenders or the
investor to take the credit risk as per their capacity and it also can be
applied in various places. The application and advantage of credit derivative
will try to explain such ground for the usage of credit derivative products and
their advantage. Credit derivative decompose and strip the credit risk from the
securities which enables the credit risk to be managed independently of other
risk they also can be tailored to the specification required of the buyer of
credit protection which makes the credit derivative product complex as well as
sophisticated.
Basically,
credit derivative are used for hedging the credit risk; this includes credit
default risk, dynamic credit risk and changes in credit quality. In the broad
sense, they are treated as the financial shock absorber of the economy and
hence helps to create macroeconomic and financial stability.
The
unfunded credit derivative product (which will be discussed later) are the off
balance item. The off-balance sheet items are not shown in the balance sheet of
the company, so that they enjoy higher flexibility and leverage like other
financial derivative. The other advantage is from the point of buyer of credit
derivative is that the credit derivative allows investor to access new assets
class (example: syndicate loan). Earlier this type of loan was only accessible
by limited market participant. The higher leverage built in credit derivative
market makes it more attractive to take the exposure via a credit derivative
than that of cash instrument.
In
the daily life, the commercial bank, the saving and loan association, finance
companies, etc. can use credit derivative to hedge their credit risk on the
loan that they have provided. The credit derivative transfer the risk in
specific loan to third parties, which is called hedging of risk. This is done
by creating synthetic short position by the use of credit derivative. The bank
can also take new exposure by creating synthetic long position on loan or other
instrument with the help of credit derivative product. This kind of activities
would have been impossible without the existence of credit derivative product.
Also, short position can be taken with credit derivative without risk of
liquidity or delivery squeeze as it is a specific credit risk which is being
traded. This can be generalized with the example that, it is not possible to
trade ‘short sell’ a bank loan in cash market but a credit derivative product
can be used to establish synthetically the economic effect of such position.
Last
but not the least advantage of credit derivative instrument is that it enables
the creation of synthetic instrument of any desire maturity. For example: a
seller of protection of credit derivative can take three years of credit
exposure to a given entity even though if there is no three years credit issued
by the counterparty.
Funded
and Unfunded Contract
Credit
derivative products are classified into funded and unfunded instruments. In the
funded contract, the insurance protection payment is made to the buyer of contract
at the beginning. If the credit event of risk occurs before the maturity of the
contract, the buyer of the contract is compensated by the insurance protection
amount made at the beginning of the transaction. If no such event occurs, the
payment is returned to the protection seller. On the other hand in the unfunded
contract the protection payment is made if the event of risk occurs, before the
maturity of the contract. That means, the protection seller do not have to make
an upfront payment of the protection to the buyer of the contract at the
beginning of the transaction. Moreover, if no such credit event of risk occur
before the maturity, no payment have to be made at all. This indicates that the
unfunded credit derivative instrument are more flexible in terms of execution.
However, a buyer of contract prefers to have funded credit derivative
instrument rather than unfunded ones. Credit Linked Noted (CNS) is a funded
credit derivative instrument whereas Credit Default Swap (CDS) is an example of
unfunded credit derivative instrument.
Types
of Credit Derivative Products
1. Credit
Default Swap: Credit Default Swap (CDS) is the most
common and most important instrument of the credit derivative market. It is
often called as credit swap or default swap. According to Choudhry (2013), A
CDS is a bilateral contract in which the protection buyer pays the periodic
fixed payment or one off premium to protection seller, in exchange the seller
will make the single contingent payment on the occurrence of specified credit
event associated with the underlying assets. The CDS enables one party, the
buyer of protection to transfer their credit risk with another party, the
seller of protection.
In the words of Sundaram
& Das, (2013) the credit event can occur in the form like failure to pay,
bankruptcy, obligation default, obligation acceleration, repudiation/moratorium
etc. The soft credit event like restructuring, which includes reduction or
postponement of interest or principal repayment are also taken as credit event
in CDS. From the investor point of view this can be explain in simple way that
an investor purchase a protection against the above mention credit event and
pays premium to the counterparty which is very much similar to buying an
insurance policy and paying insurance premium to the insurance company. The
term ‘going long’ on CDS indicates buying protection and paying premium and
vice versa.
The maturity of CDS
doesn’t necessarily need to be the same as of the maturity of underlying
assets. For example: An investor purchases a corporate bond of 10 years
maturity. Since, the bond is not free from credit risk, the investor also
purchases CDS against the credit risk associated with the corporate bond and
the maturity of this CDS doesn’t necessarily be of 10 years tenure.
Finally, the settlement
of CDS can be either physical settlement or cash settlement. The process of
physical settlement includes protection buyer delivers the defaulted obligation
to the protection seller and receives the par value of the obligation in
exchange. Where as in cash settlement the protection seller makes a cash
payment to protection buyer equal to the loss amount in credit event.
The two major types of
CDS includes Basket Default Swap and Credit Default Exchange Swap. If there are
more than one reference item in a basket, the protection taken against more
than one item or specified item in the basket is Basket Default Swap. The
specified item can be expressed in terms like first-to-default, second-to-default,
nth item to default (out of z item) or last zth item to default. In
Credit Default Exchange Swap two industries of different region or industries
can diversify their loan portfolio in a single non funded transaction by
hedging the concentrate risk of the loan portfolio. This is more in practice in
commercial bank to swap the risk of their loan portfolio.
2. Total
Return Swap: Total Return Swap (TRS) or total rate of
return swap is also a bilateral contract that exchange the total return from a
financial assets between them. According to Francis et al. (1999) A TRS is a
swap agreement in which the total return of bank loan or credit sensitive
security is exchanged for some other loan or credit sensitive security. For the
better understanding of TRS the party paying the total return of an assets is
called total return payer, the counterparty receiving the return is called
total return receiver and the specified assets is called reference obligation.
TRS was popular in early days of credit derivative market. It is one of the
principal instrument for the BFI to manage credit risk.
Total return swap not
only swap the cash flow from the interest and coupon payment but also swap the
value of capital appreciation of the underlying reference obligation. However,
there can exist the situation of capital depreciation implying the negative
value of TRS. In this situation the total return receiver makes the payment to
total return payer.
The advantage of TRS is
that it enables access to desired assets class such as syndicate loan, without
TRS this was not possible (Sundaram & Das, 2013). It also enables new
assets with various maturities that are not available in the market. That means
investors can gain efficient off balance sheet exposure to desired assets class
to which they otherwise wouldn’t have access in it. Also, investors can reduce
administrative cost through an off balance sheet purchases. The long term
investor, who feels that the reference assets in the portfolio may widen in
spread in the short term but thinks that will recover later can entered into
the TRS of shorter than the maturity period of the assets. This structure is
flexible and doesn’t require the sale of the assets, which is beneficial for
the payer of TRS.
3.
Assets Swap: In the words of Choudhry (2013), the Assets
Swap is the combination of and interest rate swap and bond which is used to
alter the cash flow profile of the bond. They are used to transform the cash
flow characteristics of bond either by fixed coupon rate bond to floating rate
bond or vice-versa. In the Assets swap the bond coupon is swapped on LIBOR plus
spread. LIBOR stands for London Interbank Offer Rate, which indicates the
benchmark rate that some of the world's leading bank charge each other for
short term loan, it serves as the initial step to calculate interest rate on
various loan throughout the globe. Assets swap can be used to transform the
cash flow characteristics of reference assets, such as bond; so that the
investor can hedge currency, credit and interest rate risk to create synthetic
investment with more suitable cash flow characteristics (Pereira, 2003). Assets
swaps are used to fulfill a variety of goals but are generally undertaken to
transform the character of an investor's assets. For example a bank may use an
assets swap to convert long term fixed rate assets to floating rate assets to
floating rate assets to match their depositors' account, which represent short
term account liabilities (fincad.com).
The buyer of the assets swap takes the
credit risk of the bond. That means, if bond defaults, the swap buyer have to
pay the interest of the bond which cannot be compensate from the underlying
bond or on the other hand the swap can be close-out at the market value. The
assets swap buyer is exposed to the loss of the coupon and redemption on the
bond. The loss on the redemption of bond occurs by the difference of the bond
price and recovery value (O'Kane, 2000). The assets swap buyer takes the
benefit of assets swap from the assets swap spread, which occur as the value
for the buyer for taking the above mention risks. The other advantage of the
asset swap is to enable an investor to take exposure to the credit quality of
the underlying assets with nominal interest rate risk and to take advantage of
mispricing in floating rate market.
There are several variations of asset swap
available in the market, however, par asset swap and cross currency asset swap
are widely used asset swap.
4.
Credit Linked Notes: Credit Linked Notes (CLNs) is one of the
unfunded off balance sheet instrument which transfer the credit risk of the
issuer to the investor through the issue and redemption of underlying
securities. Since, CLNs is an unfunded credit derivative instrument there is no
upfront payment to purchase a CDS. CLNs represent one method by which CDS are
covered into funded form. In other words it is effectively a fixed interest
instrument with CDS embedded in it. CLNs are used by the commercial bank to
manage both their credit risk exposure and balance sheet.
The upfront payment of the note is done by
the buyer of CLNs. The coupon and principal repayment of the note is tied up
with the reference obligation, since the contract is based on reference
obligation which can be one single instrument, number of instruments or market
index as mentioned in the contract. If no credit event occur with the reference
obligation then the coupon and principal payment will be done accordingly
however, if the reference obligation experience credit event then the loss in
the value of reference obligation is taken out of the note and the balance is
returned to the investor (Sundaram & Das, 2013). From the perspective of
issuer of CLNs it helps them to rise capital while protecting themselves
against the failure of counterparty. The investor benefits from enhanced yield
for the acceptance of additional risk but they are exposed to counterparty risk
of reference obligation and the issuer. The investors also can diversify their
portfolio through CLNs through two ways. First, with the help of new assets
class; second, with the access of new counterparty.
CLNs can be altered as per the requirement
of the issuer. The most common variation of the CLNs is the Special Purpose
Vehicle (or Special Purpose Entity) denoted by SPV or SPE, however they are
more complex in nature. Also, the basic CLNs can be altered by incorporating
some of the features of TRS and other security.
5.
The other type of credit derivative instruments are;
·
Credit Spread Option (CSO)
·
CDS Index Products (CDSI)
·
Constant Proportion Debt Obligation (CPDO)
·
Collateralized Debt Obligation (CDO)
Risk
inherent in Credit Derivative
Counterparty risk is
taken by each party in any or the OTC derivative, hence it is present in all
class of financial assets including equity derivative, forex, commodities and
credit derivative. So, one of the major type of risk associated in credit
derivative instrument is the counterparty risk. It is one of the sub class of
credit risk and occurs while the loan has default risk. The conditions for
counterparty risk in Credit Default Swap can be either of default of reference
entity or counterparty or both. The legal risk in credit derivative arises from
the ambiguity regarding the definition of default. This indicates that certain
thing can be termed as default in a jurisprudence whereas may not be another
jurisprudence. Also, legal provision may not define some situation, since new
credit derivative instruments continuously emerging. The regulators' of the
credit derivative may have limited scope to regulate these instruments,
eventually creating regulatory risk. The other type of risk are liquidity risk
generally occur in thin market however the market should be adequately liquid
for the existence of credit derivative and model risk which indicate the
probabilities of default are hard to estimate. Also, it may not always channel
risk to those who best handle/understand it. Finally, there are always new
innovative instrument keep appearing in this field which are not adequately
tested by the market and can create unseen risk.
Conclusion
Credit Derivative Instrument exist in the
advance capital market, where the various dimension of the market have been
adequately developed. They are the innovative instruments which helps to
minimize the credit risk associated with various financial instrument. However,
they are not able to mitigate the risk completely. Availability of these
instrument helps the market to access new assets class and help to diversify
the investors' portfolio. With no doubt, there are various pro and cons of the
credit derivative, the investor should be aware of the use and application of
the instruments. They should be able to measure and manage the counterparty
risk, correlation and liquidity. From the regulatory prospective, credit
derivative open the new horizon for market regulation, legal provisions,
capital adequacy requirement regime etc. on the other hand the regulators need
to ensure that the financial intermediary have the proper risk management
technique, which includes advance system, software, alert generation mechanism,
expertise, control mechanism in place for the credit derivative operation.
References
1. Bomfin,
A. (2003), "Understanding Credit Derivatives" Elsevier
Academic Press, London, UK
2. Choudhry,
M. (2013), "An Introduction to Credit Derivative" 2nd Ed. Butterworth
Heinemann, Oxford, UK
3. Francis,
J., Frost, J., & Whittaker, J., (1999) "The Handbook of Credit
Derivative" McGraw Hill, New York
4. http://www.fincad.com/resources/resource-library/article/valuing-asset-swaps-and-asset-swap-spreads
5. http://treasurytoday.com/2004/03/credit-derivatives-credit-linked-notes
6. Pereira,
R. (2003), "Understanding Assets Swap" An working note on
yieldcurve.com
http://www.yieldcurve.com/Mktresearch/LearningCurve/LearningCurve4.pdf
7. O'Kane,
D. (2000), "Introduction to Asset Swaps" Analytical Research
Series, January 2000 Issue, Lehman Brothers International (Europe)
8. Schöpf,
W. (2010), "Credit Default Swap Trading Strategy" Diplomic
Verlag, Hamburg, Germany
9. Sundaram,
R. & Das, S. (2013), "Derivatives: Principles and Practice"
McGraw Hill Education (India) P. Ltd. New Delhi
10. Weithers,
T. (2007). Credit Derivative, Macro Risks and Systematic Risks, Economic
Review, Federal Reserve Bank of Atlanta, 4th Quarter 2007, 43-69
Ajaya Dhungana
Officer, Securities Board of Nepal
(Published in SEBON's 26th year article collection book)
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