1. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Topic No. 8b
Credit Derivatives
Course BWRR 3063Course BWRR 3063
Financial Risk ManagementFinancial Risk Management
Prepared by:
Abmalek F. Abubakar
School of Economics, Finance & Banking
UUM College of Business
abmalek@uum.edu.my
Tel : (Office) 04-928 6865
(H/P) 012-386 3764

2. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Selected credit derivatives
 credit default swaps (CDS),
 total return swaps (TRS), and
 credit-linked notes (CLN).
Contents

3. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
What is Credit Derivative?
A credit derivative is a financial instrument the value of
which is determined by the default risk of an underlying
asset.
Definition
http://www.investinganswers.com/financial-dictionary/optionsderivatives/credit-derivative-1338

4. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit derivatives are off-balance sheet financial instruments
that allow one party (the risk seller or protection buyer) to
transfer the credit risk of a ”reference asset,” which it
normally owns, to another party (the protection seller or
guarantor) without actually selling the asset. In other words,
credit derivatives enable investors to efficiently transfer and
repackage credit risk.
What are Credit Derivatives?
Definition
http://www.lehman.com

5. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
How credit derivative works
•Credit derivatives allow a lender or borrower to transfer the
default risk of a loan to a third party.
•Though the terms differ from one credit derivative to another,
the general procedure is for a lending party to enter into an
agreement with a counterparty (usually another lender), who
agrees, for a fee, to cover any losses incurred in the event
that a borrower defaults.
•If the borrower does not default, then the counterparty that
provides the insurance pays nothing to the original lender and
keeps the fee as a gain.
Definition

6. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Illustration
•Suppose XYZ Bank lends $10m to Bell Inc. over 10 years.
•Worried that Bell Inc. carries significant default risk as a
borrower, XYZ Bank enters into a credit derivative with ABC
Insurance.
•The terms of the agreement state that in the event Bell Inc.
defaults and is unable to repay the loan, ABC Insurance will
compensate XYZ Bank for the remaining interest and principal in
return for an annual fee of, say, $50k through the end of the 10-
year term.
•If Bell Inc. does not default on the loan, ABC Insurance may
keep the $50k annual fee as a gain.
Definition

7. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Specifically, banks use credit derivatives for the following
purposes:
•To hedge credit risk;
•To reduce risk concentrations on their balance sheets; and
•To free up regulatory capital.
Uses of Credit Derivatives

8. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit derivatives take many forms. Three basic structures
include:
1.Credit Default Swap (CDS)
2.Total Return Swap (TRS)
3.Credit-Linked Notes (CLN)
Types of Credit Derivatives

9. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Default Swap
(CDS)

10. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• A CDS is a contractual agreement to transfer the default risk
of one or more reference entities from one party to the other.
• One party, the protection buyer, pays a periodic fee to the
other party, the protection seller, during the term of the
CDS.
• If the reference entity defaults or declares bankrupt or
another credit event occurs, the protection seller is obligated
to compensate the protection buyer for the loss by means of
a specified settlement procedure.
• The reference entity is not a party to the contract, and the
buyer or seller need not obtain the reference entity’s consent
to enter into a CDS.
Credit Default Swap (CDS)

11. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Default Swap (CDS)
•Credit events are typically defined to include a material
default, bankruptcy or debt restructuring for a specified
reference entity.
•If such a credit event occurs, the seller of protection makes
a payment to the buyer of protection, and the swap then
terminates.
•The size of the payment is usually linked to the decline in
the reference asset’s market value following the credit event.
Credit Default Swap (CDS)

12. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Protection Buyer
(Bank XYZ)
Protection Seller
(Insurance Co. ABC)
pays premium fee
contingent payment
on credit default
Reference Entity
(Bell Inc. Loan)
Credit Default Swap (CDS)
Transfer risks

13. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
As to the settlement, the protection seller compensates the
buyer in the event of default.
There are two types of settlement:
•physical settlement, and
•cash settlement.
Credit Default Swap (CDS)
Settlement of CDS

14. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Default Swap (CDS)
• If a credit event triggers a CDS with physical settlement,
the protection buyer delivers to the protection seller the
defaulted reference entity with a face value equal to the
notional amount specified in the CDS.
• In return, the protection seller pays the par value of the
debt.
Settlement of CDS – Physical Settlement

15. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• If the event occurs in a CDS with cash settlement, an
auction of the defaulted bonds takes place to determine the
post default market value.
• The protection seller then pays the buyer the difference
between the par value, which is equal to the CDS notional
amount, and the post default market value.
Credit Default Swap (CDS)
Settlement of CDS – Cash Settlement

16. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Total Return Swap
(TRS)

17. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• An agreement that allows a counterparty to transfer the
total economic risk both credit risk and market risk of an
underlying asset or portfolio of assets to another
counterparty without transferring the asset itself. (A default
swap transfers only credit risk to the counterparty.)
• The holder of an asset wishing to hedge exposure to that
asset pays the total return (all interim cash flows and any
change in positive mark-to-market value) of a reference
asset and (usually) receives Libor plus a fixed spread and
any capital depreciation from the other counterparty.
The concept
Total Return Swap (TRS)

18. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
•Two parties enter into an agreement whereby they swap
periodic payment over the specified life of the agreement.
•One party makes payments based upon the total return—
coupons plus capital gains or losses—of a specified reference
asset.
•The other makes fixed or floating payments as with a vanilla
interest rate swap.
•Both parties’ payments are based upon the same notional
amount.
•The reference asset can be almost any asset, index or basket
of assets.
Total Return Swap (TRS)

19. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• The total return payer normally owns the reference
obligation and agrees to pay the total return on the
reference obligation to the receiver.
• The total return is generally equal to interest plus fees plus
the appreciation or depreciation of the reference obligation.
• The total return receiver, for its part, will pay a money
market rate, usually LIBOR (London Interbank Offered
Rate), plus a negotiated spread, which is generally
independent of the reference obligation performance.
Total Return Swap (TRS)
How does a TRS works?

20. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• If a credit event or a major decline in market value occurs,
the total return will become negative, so the receiver will
end up compensating the payer.
• The end result of a total return swap is that the total return
payer is relieved of economic exposure to the reference
obligation but has taken on counterparty exposure to the
total return receiver.
Total Return Swap (TRS)
How does a TRS works? (contd.)

21. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Total
Return
Receiver
Total
Return
Payer
Reference
Obligation
LIBOR plus
x basis points
TR of
Reference
Obligation
TR of
Reference
Obligation
Funding Cost
(≤ LIBOR)
Total Return Swap (TRS)
Total Return Swap
Total return (TR) = interest + fees ± (appreciation/depreciation) – default losses

22. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• The fundamental difference between a credit default swap
and a total return swap is the fact that the credit default
swap provides protection against specific credit events.
• The total return swap provides protection against loss of
value irrespective of cause—a default, market sentiment
causing credit spreads to widen, etc.
• Most credit derivatives entail two sources of credit
exposure: one from the reference asset and the other from
possible default by the counterparty to the transaction.
CDS vs TRS

23. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit-Linked Notes
(CLN)

24. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Linked Note (CLN)
•A debt instrument is bundled with an embedded credit
derivative.
•In exchange for a higher yield on the note, investors accept
exposure to a specified credit event.
•For example, a note might provide for principal repayment to
be reduced below par in the event that a reference asset
defaults prior to the maturity of the note.
Credit Linked Notes (CLN)

25. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• A credit-linked note (CLN) is essentially a funded CDS,
which transfers credit risk from the note issuer to the
investor.
• The issuer receives the issue price for each CLN from the
investor and invests this in low-risk collateral.
• If a credit event is declared, the issuer sells the collateral
and keeps the difference between the face value and
market value of the reference entity’s debt.
Credit Linked Notes (CLN)

26. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
• Bank A extend a $1 million loan to a Steel Company and it
wishes to hedge against the company defaults.
• At same time Bank A issues to institutional investors an
equal principal amount of credit-linked notes, whose value
is tied to the value of the loan.
• If a credit event occurs, Bank A’s repayment obligation on
the notes will decrease by just enough to offset its loss on
the loan.
Credit Linked Notes (CLN)
Example

27. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Bank A
Institutional
Investors
Steel Company
fixed or floating
coupon,if defaults
or declares
bankruptcy the
investors receive
an amount equal to
the recovery rate
$1 Million
500bp
Steel
Company
$1million
Illustration
Credit Linked Notes (CLN)

28. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Mitigation
Credit Derivatives (contd.)
• Credit derivatives are used for
 investment and trading, as well as
 management of credit risk in banking and portfolio
management
• It exist in a number of forms. The 2 main types are
 funded credit derivatives, and
 unfunded credit derivatives

29. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
For the protection buyer (the risk seller)
• to transfer credit risk on an entity without transferring the
underlying instrument
• regulatory benefit
• reduction of specific concentrations portfolio management
• to go short credit risk

30. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
For the protection seller (the risk buyer)
• diversification
• leveraged exposure to a particular credit
• access to an asset which may not otherwise be available
to the risk buyer sourcing ability
• increase yield

31. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Options

32. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
Credit Options are put or call options on the price of either
(a)a floating rate note, bond, or loan, or
(b)an “asset swap” package, which consists of a credit-risky
instrument with any payment characteristics and a
corresponding derivative contract that exchanges the cash
flows of that instrument for a floating rate cash flow stream.
Credit Options

33. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014
In the case of a floating rate note, bond, or loan , the Credit
Put (or Call) Option grants the Option Buyer the right, but not
the obligation, to sell to (or buy from) the Option Seller a
specified floating rate Reference Asset at a prespecified
price (the “Strike Price”).
Settlement may be on a cash or physical basis.
Credit Options

34. UUM College of Business BWRR3063 Financial Risk Management
Credit Derivatives
© Abmalek F. Abubakar, 2014