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| ÖCredit Derivatives from 1999Our Credit Derivatives Pages: Current 1999 1998Ask Dr. RiskEmerging markets arbitrage (7/28/99)Dear Dr Risk – I am a trainee trader-analyst in a London based hedge fund that operates mainly on the emerging markets. I have read your opinion about credit derivatives models, and their substantial lack of usefulness in operative trading. I would like to know where can I find some publication about emerging markets arbitrage, really implemented in the market, and what they are about. From what i have seen, infact, instruments used are quite simple; i'd like to know what are approaches to more complex products. – G.M. Dear G.M. – The approaches to more complex products in emerging markets are either unconventional or strictly hypothetical. The conventional approach involves hedging, which is more difficult in emerging markets, virtually by definition. Let's consider the simple instruments – credit swaps, total return swaps, and notes linked to them. In developed markets, for well-known names, hedging those instruments is easy, where the dealers can find the underlying credits to buy, short, or asset swap. For less well-known names this process is difficult even in developed markets. In a sense, the market for the underlying name’s debt isn’t developed. In emerging markets, the conventional solution, hedging, is not available, because the liquid underlying market isn't there in almost any cases, except perhaps for sovereign debt. That's my theory, from afar, based on my glimpses of currency, equity, and fixed income derivatives in emerging markets. Would you agree, based on your observations? Now, consider more complex structures, such as credit protection on the first-of-five bonds to default. We have lots of interesting, even beautiful theories about pricing. In perfect markets we could do a decent job of pricing such complex credit derivatives. We just need the data: default probabilities, default correlations, etc. However, my opinion is that even in developed markets these beautiful theories have totally impractical data requirements. The situation is probably nearly impossible in emerging markets. I haven't seen discussions of this, but I'd say that one might be able to approach credit options in emerging markets via standard underwriting practices and diversification. To the degree that banks operating in emerging markets make loans, they have some method for assessing and pricing default risk. They could use the same method to price and manage the risk of some credit derivatives. Global diversification of credit risk might be feasible. For example, a Brazilian bank might swap loans with a Thai bank. This is analogous to a bank in Georgia swapping its loans to peanut farmers for a New York bank’s loans to exporters. Of course, recent history tells us that global economic problems can be contagious, so the diversification may not work. Also, each of these banks face the usual problem that the other bank might swap out its "lemons". – Dr. Risk Trying to stay afloat with credit derivatives (6/28/99)Dear Dr. Risk – We have 3 ships and 2 problems. 1. We have dollar loans. Interested in Currency Swap to Yen. However due to conuterparty risk, banks are asking for cash collateral for swap arrangement. Can you suggest a suitable derivative , which we could present to the banker, satisfying their credit risk and enabling the Currency swap. 2. Also, is it possible for floating assets like Ship purchases to be covered in Credit derivatives for our lenders, so that we can leverage our positions. Can you suggest a suitable strucuture without collatearlising. – Krishna Dear Krishna – Your problems boil down to finding a way to assure prospective creditors that you will meet your obligations, without providing customary collateral. This will be a tough sale. In South Asian terms: It’s a bit like finding a husband for your daughter, while refusing to provide the customary dowry. [Westerners: It's like a man trying to persuade an American woman to become his fiancée, while adamantly refusing to buy her a diamond engagement ring. Nobody takes the proposal seriously, until she's wearing a rock that costs a few months of the man's salary. Now, if he's a cad and defaults, she's got collateral!] Can you really blame a prospective lender – or groom’s family [or bride] – for saying no, under those circumstances? Assuming that the bankers are professionals, they are making reasonable requests and have thought of alternative structures that won’t work to get them the desirable business. They aren't going to come around. You're going to have to either remove the risk with collateral, or pay someone for taking the risk (i.e., insurance or guarantee) and protect them from abuse. What are the banks telling you when they demand cash collateral, rather than your ships? The role of collateral is to increase the probability that you keep your promise to repay. Maybe, the banks don't understand the ship market, or maybe ships are too risky or too illiquid. Maybe, your ships aren't worth enough. How much cash collateral are the banks demanding, and what is the liquidation value of your ships? How fast could that value collapse? I don't think a credit derivatives structure will solve either
of your problems. Ordinarily, a credit derivative presupposes a
liquid market in the underlying risk factor. In your case, that
would be your risky debt. Hypothetically, in lieu of a liquid market for hedging the credit derivative, a rational credit derivatives dealer would require the same underwriting process as lending, before selling credit protection to the bankers. In particular, I presume that the credit derivatives dealers would require the same collateral that the bankers are demanding. – Dr. Risk P.S. I get so many technical questions about how to
do something specific, but, often, the first thing that comes to
mind are questions, such as In your case, your questions to me begs more fundamental questions: 1. Why do the currency swap? You're bullish on dollars and bearish on yen? Then maybe you should short yen futures on the Chicago Mercantile Exchange. Of course, even there you would have to put up liquid collateral. 2. Why not put up cash collateral? Are you having trouble borrowing more? That's the market's way of telling you that you're over extended. Do you foresee a relatively high probability of default, hence you want to let someone else bear the loss? That may be what the potential creditors see, so they're being prudent. You'll have to shop around for a sleepy lender. 3. Why do you want to lever so much? Is the opportunity so good? Then why not give up some of the upside with equity financing? 4. Why use credit derivatives? Why not use collateral, a loan guarantee, or credit insurance? Disclose all the information about your current situation so the third party can underwrite the risk, put the party in sufficient control of your future actions so it can protect its interest, and compensate that party for backing you and taking your credit risk. Sounds less appealing than putting up cash collateral? A guarantor or insurer wouldn't consider the idea of guaranteeing or insuring your credit without proper information and controls. They have to be in the customer's business (but politely) or out of their own business, due to fraud. Hedging Credit Derivatives – Impossible Dream? (5/28/99)Dear Dr. Risk – I HAVE ONE VERY CONFUSION QUESTION :HOW CAN HEDGE ANY TYPE OF CREDIT DRIVATIVES"? WHAT DOES IT MEAN "HEDGING OF CREDIT DERIVATIVES" ? IS IT REALY POSSIBLE TO HEDGE CREDIT RISK DERIVATIVES? THANKS A LOT ALL YOUR COMMENT AND HELPING ME. SINCERELY – Adragon Dear Adragon – Credit derivatives come in many varieties. You can hedge some types of credit derivatives relatively well and easily, but hedging many others is a wild fantasy – in 1999. If you can replicate a long credit default swap by buying a AAA bond and shorting a credit-risky asset swap, then you can hedge a short credit default swap by buying the replicating portfolio. You can hedge a total return swap the same way. For everthing else, I wouldn't bet my life on the hedge performance. – Dr. Risk Credit Derivatives Pricing Models (5/28/99)Dear Dr. Risk – I'm an italian student; I'm getting graduated at university of Bologna, and as u know, I've to write down a thesis, the subject I choose is credit derivatives, in particular credit default option and credit spread option.I'm trying to make an empirical verify for the italian market,I got some pricing model:1998's Das,1995's Longstaff and Schwartz and finally another one,downloaded from the net made by Skora;according to your opinion are they ok?May I continue walking this way? Second matter I need to elaborate historicals data but, as u know, italian financial market is a bit thick and it's difficult to have datas could please send any american operator's E-address to ask for this datas (expecially option prices) even regarding american market,or it'll be the same if tell me about any sites showing market prices for options such as C.M.E.'s site....... Third,and for your relief,last question,I've also to write down a background dealing with regulatory profiles and after five days I still can't etabilish any connection with FED's site (www.bob.frb.fed.us):I REALLY DO NEED supervisory guidance SR 97-21......in the case u would send......... – Massimilano Dear Massimilano – You question reminds me of an old Groucho Marx movie, where a woman in a tight dress says to him, "Walk this way, please." He replies, something like, "If I walk that way, I'm gonna need some talcum powder." But, of course, that's not really relevant, so back to your main concerns.
Good luck! – Dr. Risk Interest Rate Parity with Default Risk (5/28/99)Dear Dr. Risk – Here's a problem from a trading floor. As an investor of foreign debt I have both the FX risk and the credit risk. There is strong evidence that the two risks are correlated. In order to study this problem formally I feel we have to revise interest rate parity if there is no risk free domestic and foreign bonds. I am just wondering if there is any studies in this area and your thought on this problem. – Dave Dear Dave – This is a really interesting question, and challenging. Here's my first impression. Ordinary interest rate parity theory (IRPT) assumes default free debt in countries A and B. However, it clearly allows random changes in the exchange rate between the two currencies. Formally, from the point of view of the investor in country A, devaluation of country B's currency is like a proportional partial default on all the debt in the country B. Yet, IRPT handles this, easily. The IRPT equation relates the spot and forward exchange rates and the domestic and foreign rates of interest: FX = X e(Rd-Rf)T where X and FX are the spot and forward exchange rates, both in units of domestic currency / foreign currency, but the dates differ, and Rd and Rf are the domestic and foreign rates of interest. If you have any three of the four – FX, X, Rd, and Rf – then you can deduce the last. You have a similar situation in each country with the riskless debt and credit-risky debt, forgetting about exchange rates. You could have spot and promised forward values for the debt, plus riskless and promised rates of interest. They would have to be in line, in equilibrium. I think a key problem is when you don't have a liquid forward market in the credit-risky debt or a liquid market in default-free debt. Thus, you have an equation with two unknowns. My initial remark suggested stripping away the credit risk, which would give you the liquid market in default-free debt. Then, you could deduce the forward price for the debt from the usual IRPT equation. Of course, I can say this easier than you can do it. See what I'm saying? What do you think? – Dr. Risk Dear Dr. Risk – There are a few cases we could encounter: A) Both countries have only risky bond market I am pretty convinced that in case A, you have to modify IRPT to take consideration of credit risk. Using Duffie and Singleton approach to default treatment, the FX forward rate would be determined by the RISKY interest rate (which is the sum of risk free + mean loss). The arbitrage argument is a kind of based on the expectation where the expectation is taken with respect to the credit risk. I have trouble to understand cases B and C where you have at least one country which has both risk-free and risky bond market. In these cases, should the FX forward rate be UNIQUELY determined based on the risk-free interest rate differantials only or should also be consistant with the risky interest rate? – Dave Dear Dave – Between what you've said and what I said, I think you are about an inch from your answer. However, perhaps the main thing missing is a clear statement of your question. You might start by stating clearly the question that IRPT answers. Then, what do you want to say? Then do the algebra. Here's one idea: For default-risky debt, the value of a zero coupon bond is Z = FACE / [1 + (R+LP)T], where L is the loss rate and P is the probability of default. Hence, Z (1+RT) = FACE / [1 + LPT/(1+RT)]. This is true for both domestic and foreign markets, hence, for Zd and Zf. Choose Zd/Zf = X = FACEd / [1 + (Rd+LdPd)T] / {FACEf / [1 + (Rf+LfPf)T]}. What is an IRPT analog for this case? How about FX = X (1+RdT) / (1+RfT) = FACEd / [1+(Rd+LdPd)T] / {FACEf / [1+(Rf+LfPf)T]} = (FACEd / FACEf ) [1 + LfPfT/(1+RfT)] / [1 + LdPdT/(1+RdT)]. Hence, the equilibrium ratio of promised, but credit risky forward face amounts for the debt in the two countries is FACEd / FACEf = X [1 + (Rd+LdPd)T] / [1+(Rf+LfPf)T] = FX [(1+RfT) / (1+RdT)] {[1+(Rd+LdPd)T] / [1+(Rf+LfPf)T]}, where FX is the usual, equilibrium ratio of credit-riskless forward face amounts of the debt. I think you can address your cases A, B, and C in this framework. If both probabilities of default are zero, then the expression reduces to the usual IRPT for promised and actual forward face amounts. – Dr. Risk Private, individual credit insurance #1 (3/28/99)Dear Dr. Risk – Please send me information or access to requested information via www, organization or specialty industry association regards: Credit Insurance for Individual, Private borrowers who intend to lease purchase equipment for their office or business premise. – Carlo Dear Carlo – I have no solid information or references on this topic, but can't resist the urge to comment. Credit insurance for an individual borrower might have precisely the same terms as credit insurance for a corporate borrower. Let's say the policy's payoff equals Max(0, 100 - B) at the loan's maturity. However, I can imagine that the underwriting process for the individual's insurance might differ greatly from that for a large, publicly traded corporation. For the corporate debt insurance, at least for larger corporations, the underwriter might be able to hedge his risk by shorting the corporation's debt. This is a classical risk management tool for a derivatives desk For individual debt insurance and insurance for smaller corporations, hedging wouldn't ordinarily be practical, except (conceivably) for an individual such as a Donald Trump. The only practical approach to managing this sort of risk would be by diversification, through writing many policies of this sort. This is the standard risk management tool for an insurance company. – Dr. Risk Private, individual credit insurance #2 (5/28/99)Dear Carlo – Your request for information seemed to focus on ways that a single creditor could obtain credit insurance on loan to finance the purchase of business equipment. Upon reflection and research, I have some more ideas and a web site. 1. I believe that credit cards make this insurance unnecessary in many cases. The credit card issuer underwrites the debtor, steps in place of the vendor as creditor, and no one insures the credit. 2. In previous years, a common solution to the personal credit problem was finding someone, often a relative, to cosign the loan. This is a guarantee, rather than insurance, and the guarantor is not ordinarily in the guarantee business. This approach has made it possible for many persons to obtain loans that would not have been otherwise available. Subsequent defaults have also created stress in many families. 3. An insurance policy that covers all the trade credit that a vendor extends is more common than a policy that insures all the trade credit that a buyer obtains. Richard T. Opie & Co's web site, http://opie-credit-insurance.com outlines the nature of this commercial credit insurance business Mr. Opie, an experienced credit insurance broker, has enlightened Dr. Risk about additional aspects of the business. According to Mr. Opie, "First, the insuror underwrites all larger credit lines before agreeing to cover same. Credit insurors never knowlingly insure a bad risk and the insured must always share in the risk. Most commonly, via co-insurance (usually 20%). This discourages the insured from any temptation to throw credit judgment out the window." This makes a lot of sense. Dr. Risk finds it intriguing that he has not seen such thinking in sales literature and and presentations about credit derivatives. Where perfect hedging is possible – for products such as credit swaps and total return swaps, at least with liquid markets in the underlying instruments – underwriting and credit judgment may be superfluous. However, in other cases, it would seem to be essential. – Dr. Risk Credit default swap vs. credit default option (3/28/99)Dear Dr. Risk – I'm Marco, italian student. Could you tell me difference between Credit Defalut Swap and Option? For me are the same, I have read in Tavakoli's book the same reason and also Mr Das told me the same thing. He told me that it's only terminologic problem. But I have read in Merrill Lynch paper and in Jp Morgan that Default swap is a swap not an option. In ML paper they say that in t(0) contract value is 0. But if it is an option is value can't be zero (also it's out of the money) Could you help me? – Marco Dear Marco – The idea that a credit default swap and a credit default option could be the same thing seems puzzling, at first, particularly since their payoff functions are really different! However, the payoff functions are the same for all practical purposes (which I shall define). Define the final payoff for a credit default swap as 100 - B at the swap's maturity, which equals the bond's maturity. The swap also has regular cash outflows. Define the payoff for a credit default option that expires at the bond's maturity as Max(0, 100 - B). The key point is that at the bond's maturity the corresponding bond in the swap will never be worth more than par. Thus, the swap and option payoff functions differ, because 100 - B ¹ Max(0, 100 - B). However, 100 - B = Max(0, 100 - B), except on a set of measure zero, because B > 100 won't happen. I don't know which Merrill Lynch and JP Morgan publications and/or products you mean. The key point is that anybody can call anything anything. Although credit default swap (= credit swap) is a fairly standard term, nothing stops somebody from calling something different the same thing or the same thing something different. The contract, perhaps as the confirm expresses it, rules. Are you 100% sure that the Merrill Lynch and JP Morgan products are the same as what Das and Tavakoli discuss? – Dr. Risk Credit default swap and asset swap (3/28/99)Dear Dr. Risk – Why do you consider Asset Swap as a Credit Derivatives? – Marco Dear Marco – Are you sure you aren't a law student? Next, you'll be asking me when I stopped beating my wife. Your question contains a false premise, which I would like to correct. I am not now, nor was I ever, a member of a group that considers an asset swap a credit derivative. However, I do believe that a credit default swap's replicating portfolio is long a credit riskless floating rate note and short an asset swap with an underlying credit risky fixed rate note. Pricing a credit swap at the cost of its replicating portfolio (plus a little bit to cover overhead) is the one practical, reliable way to price credit derivatives – when it's available. – Dr. Risk Letter of credit and bond insurance (3/28/99)Dear Dr. Risk – Could you tell 2 good definitions about Letter of credit and Bond Insurance? – Marco Dear Marco – As you no doubt know, the letter of credit and the bond insurance are two ways to reduce credit risk. Let's explore that idea in more detail. LETTER OF CREDIT Letter of credit (LC) has two main definitions. In a way, one kind of LC increases credit risk and the other moves it around. 1. The circular LC is a lot like a traveler's check that you can use only to get cash at a specific bank. Your give your bank X units of your currency (say, lira) and it issues an LC for X lira. If you deliver the letter to a specified foreign bank, it gives you X lira or the equivalent in foreign currency (minus something for its trouble). The circular LC replaces the danger that someone will take your money with the danger that the foreign bank won't give you your money when you ask for it. 2. In international trade Importer "opens" an LC with Importer's Bank. This means that Importer arranges with Importer's Bank (the "issuing bank") to issue an LC that is negotiable at Exporter's Bank (the "negotiating bank"). The terms of the LC say that Exporter's Bank will deliver X lira (say) to the Exporter if Exporter presents the LC and satisfies its conditions. The conditions are things like presenting trade documents that indicate that Exporter has delivered the goods at the right time and place, and in the right quality, and quantity. A revocable (an irrevocable ) LC is one that either (neither) the issuing bank and Importer can revoke. The negotiating bank will honor a confirmed LC, even if the issuing bank fails to pay. The negotiating bank will honor an unconfirmed LC only if the issuing bank pays. Thus, the confirmed LC has a significant component of credit risk to it. The negotiating bank takes the issuing bank's credit. This eliminates the need for Exporter to take Importer's credit. Basic business sense indicates that the negotiating bank gets some money for taking that risk, and that the greater the risk, the greater the money. BOND INSURANCE Bond insurance is a contract that promises the bondholder a payment (maybe not payment in full) in case the debtor defaults. A bond guarantee is a contract that puts the guarantor in place of the debtor, in case of debtor's default. Thus, a guarantee seems to promise payment in full of the bond's interest and principal and is like insurance that pays off enough to make the borrower whole. Of course, we have to ask, "Who guarantees the guarantor?" By the way, in expert usage, the term, "assurance", applies to events, such as death, that must happen. The term, "insurance", applies to events that may happen, such as fire, theft, or flood. Thus, life assurance and fire insurance. – Dr. Risk Fixed or floating underlying debt for credit default swaps? (3/28/99)Dear Dr. Risk – And then ... Can i write Credit Spread options also on Fixed rate bond? or only on floating rate bond? – Marco Dear Marco – For fixed rate bonds, let's define the credit spread as the yield on the credit risky bond minus the yield on the otherwise equivalent, credit riskless bond. This yield is easy to define as the bond-equivalent yield that equates the bond's price with the present value of its future coupons and principal repayment. If two bonds have the same fixed coupon, the one with the greater credit risk will have the smaller value, the higher yield, and the larger credit spread. For floating rate bonds, we don't know what the cash flows are, and we can't define a yield or a credit spread in the traditional way. Of course, if you were willing to make some assumption, then you could come up with a yield. Similarly, we can compute the yield to first call on a callable bond, even though we don't know its cash flows with certainty. I'm not willing to make such an assumption and not aware of a standard market convention. (Perhaps some reader can inform Dr. Risk on this point.) How do you define the yield on the credit risky and credit riskless floating rate bonds? You tell me that, and the difference between the two is the credit spread. If you get this far, then you may have a definition for the underlying for a credit spread option. – Dr. Risk Regulatory capital and credit derivatives (2/28/99)Dear Dr. Risk – I am from Switzerland where Asset-backed securities transactions aren't numerous yet. Maybe governmental regulations together with the complicated structure are reasons for this delay. Aren't there possibilities besides the ABS-transactions to get assets off the balance sheet to avoid the regulations of the Bank for International Settlement which demands 8 % equity for your assets and in the same time to get liquidity which you can invest in more profitable businesses. Are there instruments like Default Swaps which transfer the credit risk to another party. And if there are such instruments, how do they work and how has the market (OTC) for them developed? Thank you – Adi Dear Adi – You ask some good questions. 1. ABS transactions get assets off the balance sheets into special purpose vehicles, trusts, and the like, that provide a box that keeps the risk away from the originators that unloaded the assets. The downside of the approach is its expense (legal documents, trustees, etc.) and the moral hazard issue – maybe the originator will tend to try to pack the box with "lemons". There are ways around this "lemon" problem, a topic in itself. 2. Alternative ways away from this risk include guarantees, insurance, diversification, and credit derivatives. The insurance and guarantees are virtually indistinguishable, but only a regulated insurance company can issue insurance and call it that. A credit derivative can look a lot like insurance, but it can't use the same name, or it runs afoul of insurance regulations. That's one of the main reasons for the credit derivatives market to develop – it allows commercial banks to poach on the territory of insurance companies. By the way, a credit derivative can bear a strong resemblance to a lottery, too, but nobody calls it that, because of the unpleasant aspects of gambling regulations. 3. I define and describe credit default swaps and total return swaps on this credit derivatives page. 4. One crucial point that bears some analysis is the fact that if one bank has credit risk and does a credit derivative to move it to another bank, then the 8% capital requirement hasn't disappeared, just moved. What's the advantage of that? (Not a rhetorical question, but a serious question for deep thinkers on this subject.) Have fun as you study this topic.– Dr. Risk Dear Dr. Risk – Another disadvantage of such credit derivatives like default swaps I see in the fact, that they - other than ABS constructions - don't offer you any direct liquidity. If I have understood the mechanisms of them correctly, they simply offer you a put option on your credit risk and as a consequence free you of the BIS regulations. But aren't there instruments that offer you in return for interest and principal liquidity (= expected discounted cash flows for the life of the product - risk premium) when the contract is closed. I am thinking of instruments like repos. Were there any such transactions in the OTC-market in the past. – Adi Dear Adi – I think I like your point. Let me see if I understand you. Here are two ways that the repo works: Customer buys credit risky bond for price P1 from dealer and agrees that dealer will repurchase it in two weeks at P1 ´ (1 + r ´ dt), where dt = 14/360 (actual/360) and r is the quoted, money market rate of interest. (Remember, convention is to call the transaction a repo or reverse repo from the dealer's point of view.) Customer passes coupons through to dealer. #1: Customer merely holds bond in portfolio. This is secured lending of money from customer to dealer and lending of bond from dealer to customer. #2: Customer promptly sells borrowed bond at market (P1) and repurchases it at market (P2) in two weeks. His profit if the market price falls is P1 - P2 > 0. This transaction can be part of a hedge. If customer had that bond or a similar one in portfolio and its market value fell, then loss on inventory might approximate gain on sale of repo collateral at market and repurchase at market. This has been a common hedging strategy for decades. Is that what you had in mind for the repo transaction to replace the credit derivative? By getting liquidity, did you mean that the investor who does this sells the bond and gets cash? – Dr. Risk Dear Dr. Risk – Maybe I haven' t yet understood the mechanism of a default swap correctly. First, I want to show you how I understood it. In a default swap you have two parties: Or, just in one step: The buyer of the default swap transfers the difference between planned interest payments (as in the credit-contracts of the seller) and actual payments (due to defaults) to the seller in exchange for a certain fee. So, the seller has transfered his credit risk for a certain fee. Comparing ABS and default swaps: So, the main advantage of the ABS-construct in my eyes is, that it provides the seller (originator) with some direct liquidity which you can invest in more profitable businesses the default swap doesn't.Because the ABS constructs are still quite complex and time-consuming to implement and in Switzerland the field for ABS-transactions is not as open as in the USA I tried to find another option for credit institutes by an OTC-transaction. So, I got to an instrument like a repo, where you can sell certain assets for a certain period of time and where all rights and risks connected with these assets should be transfered to the buyer and where the seller as a consequence could be freed of underlying these assets with equity. Here is my idea: For the seller the transaction can bring two advantages: I would be thankful if you could comment my ideas and maybe give me ways to better solutions. Maybe there are credit derivatives that offer the same advantages as ABS-constructs do. – Adi Answer: Dear Adi – Your understanding of the credit swap seems essentially correct, but the convention is to say that someone buys credit protection, rather than sells credit risk. Your use of "liquidity" seems to mean "turning into cash", which sounds like ONE okay definition. (Another definition of liquidity is a small bid-ask spread.) By your definition the ABS provides liquidity to the party that stuffs assets into the SPV and gets back the proceeds of the sale of its securities. The default swap is a portfolio: short credit risky debt and long AAA debt, which may be what you want, but doesn’t make you liquid in your sense. What you call indirect liquidity seems to be another way of saying that credit risk is less, so credit lines are free. I like your repo idea and think it is a possible competitor for credit derivatives and debt guarantees, in certain cases, where the market for the credit risky debt is liquid in the sense of a small bid-ask spread. The repo is a traditional method of secured borrowing for securities dealers. The repo has been a traditional tool for a customer to hedge interest rate risk, too. Freddie Mac did billions of dollars of them in the 1980s, when I worked there. The customer lends the dealer the money, takes possession of the collateral, and promptly sells it! At the end of the repo, the customer covers his sale of the collateral and delivers it to the dealer, in return for the principal plus interest. If the collateral goes down in value, then the customer makes money. If the customer does this transaction to hedge exposure to long positions in fixed income investments, then the repo allows the customer to hedge. This sort of hedge seems to be precisely what you propose for credit derivatives. I agree that it should work, in theory, in a perfect market (no transaction costs or taxes, symmetrical information). Here you bundle the secured borrowing for the seller of the credit risk instrument with the credit guarantee to the lender, who promptly sells the credit risky collateral and buys it back at the market price. Whether the collateral goes down in value because interest rates rose or credit quality fell, the effect is the same. A key issue here is another definition of "liquidity", namely the ability to buy and sell a particular instrument without getting eaten alive in the market by the bid-offer spread. I’m not optimistic that the sort of liquidity one needs to do this sort of repo hedge is common in the credit markets, where each issue is unique and the credit risk means that investors are leery about buying securities of strange companies. Of course, the issuers of credit insurance, credit guarantees, and credit derivatives and investors in asset backed securities and asset backed swaps face the same problem. – Dr. Risk Dear Dr. Risk – So, in your eyes the
ABS-construct has some advantages that beat alternative solutions
of the OTC-Market: Dear Adi – I think the ABS approach has some advantages and disadvantages. All the methods coexist in the market place. Some methods are better or worse for some counterparties or some situations. I thought I was sounding bullish on your idea of credit repos. Your point #1 is a common argument, but it contains a little bit of magic, I think. I haven't studied the ABS market as much as I'd like. Why doesn't the M&M theory work here? I don't think I agree with your point #2. Nevertheless, ABS exist. Your explanation could be right. I think your third reason is the most intriguing. I don't understand how commercial banks can survive in this industry, given that they are under the onerous BIS regulations. Maybe I'm missing an important point here. – Dr. Risk Dear Dr. Risk – Yes, you did sound bullish on my solution with Credit-Repos. Thank you for that. I don't know how the Repo Market in the United States is and if there are already credit-like repos. In Switzerland - as far as I know - the Repos are only short term and have been accepted as an instrument for liquidity only a short time ago and only for treasuries (?). Another problem - I think - would be that you aren't freed from the BIS Regulations by selling a repo. Are there already any such instruments like Credit-Repos in the USA? – Adi Dear Adi – How do BIS regulations handle repos? Good question, but I don't have an answer. It would seem logical that if you own a credit risky bond, plus you borrow the same bond and sell it, that you have no credit risk. However, the BIS rules are definitely not always logical. I haven't heard of credit repos in the US, and I've been listening. I think the problem with them may be lack of liquidity, in the sense of a large bid-ask spread. Repos work for hedging interest rate risk, because interested parties are able to trade the on-the-run Treasuries at small bid-ask spreads. However, protection against credit risk would require trading in particular securities of particular credit names, which would have larger bid-ask spreads. Thanks for your thoughts on this subject. – Dr. Risk ABS, liquidity, and alternatives (3/28/99)Dear Mr. Risk – I have read your remarks on the questions of Adi (CH). I can't agree on his Credit default swap remarks. The protection buyer transfers nothing. He just pays a premium (libor + X bp) and gets a default payment in case of default of the underlying. I don't think it's an alternative to the ABS. At most it would be a credi-linked note; but it is on-balance sheet and gives no liquidity. Therefore credit derivatives can't be an alternative to ABS in respect of financing. By the way, do you have the email adress of Adi. I am from the same cold country and facing the same problem as he does. Urgently – Frank Dear Frank – That's Doctor Risk! I see your point, but I think it's one of those glass "half full" or "half empty" things, and it depends on the meaning of liquidity and how close is close. I forwarded your message to Adi. – Dr. Risk Plain talk about credit derivatives (2/28/99)Dear Dr. Risk – Please could you explain in basic english the meaning of Total Return Swaps & Default Swaps? who uses them and why? many thanks – Lisa Dear Lisa – I hope that the definitions on my new page about credit derivatives will help out. – Dr. Risk Credit derivatives pricing and trading volume (2/28/99)Dear Dr. Risk – My name is Christian I woudl like to ask you if have any information about pricing Credit Derivatives and date about the size of the market of these instruments. I have already read the books you suggested but they do not really help me so much. Thanking you in advance. – Christian Dear Christian – I have a new page about credit derivatives. I’ll be putting information there, from time to time. Some of it will be for the general public, some for "alumni" of my courses. I’ll probably have some information about pricing simple credit derivatives, before long. Right now, that’s the best I can offer. – Dr. Risk "There ain't no such thing as a free lunch" in credit derivatives (2/28/99)Dear Dr. Risk – i would like to get your class notes and question/answer , i live in nycity ,i am ph.d student and my main field is credit derivatives , please add me your mailling list and i love to get you material for credit derivativer – adragon Dear Adragon – i would like to send you all that material but you're not on my list of former students of credit derivatives ,if you look very closely at the "credit derivatives problems" section above you will see that i offer to send additional material to former registered students only – Dr. Risk Credit derivatives trading volume (I) (2/28/99)Dear Dr. Risk – I am doing some research into the volume of credit derivatives. Could you suggest where I may get this information? Thanks – Avi Dear Avi – Firms don't like to give out that sort of proprietary information, which has monetary value to them. However, they give it to regulators and trade associations, who may pass it along. The regulators want to know about the markets they regulate. The firms in the market want are sometimes willing to trade information about their volumes, in order to get information about everybody else's volume. The vast majority of all such trades are in New York and London, so I'd try the relevant regulators: Federal Reserve Board, SEC, Bank of England, and SFA. I believe that ISDA has published such information. – Dr. Risk Credit derivatives trading volume (II) (3/28/99)Dear Dr. Risk – The only reliable data is for US commercial banks and is published by the OCC [Office of the Controller of the Currency – Ed.] on a quarterly basis. The BBA has attempted to estimate the number but it's GIGO data. When the latest BIS survey data is released worldwide this will have cred deriv data - the Japanese released early and then withdrew the other week. – Paul Dear Paul – Thanks for the tip. I went to the OCC web site and their links to their quarterly numbers. For 98Q3 on p. 8 I see graph 4 and the corresponding table, which indicate credit derivatives with notional amount of $150 billion for the top seven banks, $12 billion for the other 457 banks, $162 billion for 464 banks. The nearby text indicated that the OCC just started reporting this aggregate figure in 1997 and provides no breakdown by type of credit derivative, even swap versus option. (Of course a credit default swap is for all significant purposes an option.) The corresponding figures for 464 banks are forwards & futures $11,644 B, swaps $12,369, and options $8,467. Thus, the credit derivatives are a mere $150 billion drop in a $32,641 billion bucket! – Dr. Risk Credit default swaps (2/28/99)Dear Dr. Risk – I am preparing my dissertation on the Credit Default Swaps and I am trying to collect as much information as possible. If you can send me any kind of information regarding that subject it will very helpful. – Gianni Dear Gianni – My credit derivatives page contains everything that I make public. I offer additional material to former registered students, and even more is in my course on credit derivatives. The Das and Tavakoli books [See book icons and links to vendor, below. – Ed.] on credit derivatives have a great deal of relevant information. Collect information on asset swaps, too, because that's the usual basis for pricing credit default swaps.– Dr. Risk Dear Dr. Risk – Thank you for the information you gave. I'll surely buy that book and if you wish I'll can send you a copy of my dissertation. – Gianni Dear Gianni – I'd like to see your dissertation, if it's in English. Dr. Risk's Italian is woefully weak. – Dr. Risk Credit derivatives thesis (2/28/99)Dear Dr. Risk – I'm italian student. I'm starting to elaborate my theses degree about Credit Derivatives. In particular I'm working on Credit Derivatives' pricing. I have seen about course: "Managing Credit Risk with Credit Derivatives" Could you send me papers and slides about Day two? In particular about Credit Problems? (Afternoon Session) Sincerely – Marco Dear Marco – I'm sorry that I can't send you those materials, which former students paid thousands of dollars to get. However, for just a few hundred dollars you can buy some excellent books on the subject. You can find icons for a few of them, below, with links to Amazon.com. Also, this page has now many free links to articles about credit derivatives. Good luck with your studies. – Dr. Risk Dear Dr. Risk – Sorry. I'm reading Das' book. It's very interesting. I'm working on pricing problems. Could you tell me if I have to buy Tavakoli's book too? Can I read only Das' book? There is a new book about Credit Derivatives issued by RISK. It's very expensive. Sincerely – Marco Dear Marco – I should have mentioned that I think that "credit derivatives" is too broad for a dissertation topic. A scholar out to be able to carve out easily half a dozen dissertations. For example, "Structural models for pricing first-to-default credit derivatives" might be a topic. That has only one of the three major types of models, applied to one of dozens of structures. I like all three books. Das's book is kind of like the Sunday New York Times, thick and the publication of record, but not the most accessible information. It contains a number of confirms and authoritative, raw facts. I'm a fan of Tavakoli's writing, because she seems not only to know what she's talking about, but also how to express it well, which reduces the cost of getting what information she can provide. The Risk book is expensive. I have only glanced through it, but think it looks promising. So which one or ones should you read? For dissertation research about credit derivatives, I'd say that reading all three would be reasonable. For a narrower topic, skim all three books, then read relevant portions carefully. I think of your dissertation as where you put new knowledge on the subject. You can't be sure your thoughts are new, unless you know what others have published. Three books doesn't seem excessive for finding that out. Monetary cost is always an issue, but I wonder if the cost of these three books is significant. If your university approves a dissertation on a topic, its library should contain most books on the subject, and should find a way to borrow what it doesn't own. If your university doesn't support you on this, then I have my doubts about it as an academic institution. However, providing scholars with books is standard at universities these day and has been standard for more than five hundred years. Time cost is another issue, but three books would appear to below standard for any dissertation. Also, don't forget that your dissertation is the foundation for your career, whether in business or the academic world. Three books is hardly too much to serve as a foundation. – Dr. Risk Pricing credit risk (1/28/99)Question: Dear Dr. Risk – I am a part-time PhD student and my thesis is about interest rate swaps and credit risk in banking industry. I would be grateful if you could give me some ideas and the current issues in this area and also it would provide economic value to the banking industry. I have read in fact alot of the journal articles related to this area, but I find that I got nowhere in the notations and find that some of the articles are too hard to fully understand. Any advice for me from an experienced Dr. like you? Your prompt reply would be much appreciated. Warmest regards from Downunder – Vic Answer: Dear Vic – The intersection of interest rate swaps and credit risk is a busy corner. You're dissertation should focus on a minuscule portion of the action there, and the same is true of my answer. Since you mention the tricky notation, I'll guess that you are talking about pricing credit risk for bonds and swaps. That's my focus. The literature and industry have three ways of pricing credit risk. 1. Static replication, used to price credit default swaps and total return swaps, is the most useful way for pricing credit derivatives, but only for some products. Buying protection via a credit default swap is equivalent to shorting the related floating rate note (FRN) and buying the corresponding AAA FRN. The related FRN has the same maturity, issuer, credit rating, seniority in bankruptcy, etc. The corresponding FRN is identical, but has a AAA issuer. The payoff on this portfolio equals a payment stream equal to the excess of the FRN coupon over the AAA FRN coupon, plus a contingent payment equal to the loss on the FRN upon default. In equilibrium, the value of the credit default swap should equal the value of the replicating portfolio. 2. The structural approach to credit default looks at a credit risky bond or swap as a credit riskless bond or swap, minus an option to exchange the bond or swap for the debtor's portfolio in bankruptcy. The approach is on sound theoretical footing, practical for a firm with a trivial capital structure, but questionable for a firm with a complex capital structure. The classic Black-Scholes (1973) paper and Merton's paper on risky debt are the inspiration for this literature.
Unfortunately, I would say that approaches 2 and 3 are "not ready for prime time". One is hard pressed to come up with the required information on the debtor's portfolio to complete the structural model. One has to make assumptions about the recovery rate and often about the risk neutral probability of default. I'm not going to bet my money on either of these models at this time. However, one may not have the data need to make approach 1 work, either. Making markets in credit derivatives is not for wimps or firms with weak sales forces. Complicated notation is a necessary evil in the world of credit derivatives, particularly for reduced form models. Some authors seem impelled to use needlessly complicated notation, but sometimes the complications are required. In either event, you just have to learn to love time and state subscripts. Best wishes. – Dr. Risk |
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