The Hindu Business Line : Understanding credit derivatives

This article seeks to simply explain, in a non-specialist language, what credit derivatives mean. Credit derivatives emerged during 1994-5 and over a short span of time have grown into a business recently estimated to be about $45 trillion. During the sub-prime crisis, lots of people have lost money on credit derivatives deals. The massive growth in credit derivatives, as also news of banks and insurance companies writing-off millions on credit derivatives exposures, invokes lot of interest in what credit derivatives are all about.

OTC business

Credit derivatives are a part of the over-the-counter or OTC business — they are not like exchange-traded derivatives in equities and bonds. The OTC derivatives business consists of interest rate swaps, exchange rate swaps, equity-linked swaps, property derivatives and other complex products.

A credit derivative is a device to trade in generic credit risk of an entity. The generic credit risk of an entity is the probability that the entity may suffer losses that may impair its ability to meet its liabilities, or may enter into bankruptcy or forced restructuring of its obligations. This generic credit risk is indicated by certain well defined “credit events”, defined in the documentation for credit derivatives, which, as in case of most other OTC derivatives, has been developed by International Swaps and Derivatives Association (ISDA). Therefore, two parties entering into credit derivative transaction, let us call them PB and PS, are expressing view on whether the entity in question will suffer a credit event or not. PB is the protection buyer; PS is the protection seller, and the entity whose credit risk is being traded is called the reference entity.

Credit default swap

The simplest way to understand a credit derivative would be to think of a hedging transaction. Let us say, PB has an exposure in reference entity, to the tune of $200 million. PB wants to reduce that exposure by $100 million. PB has the option of selling a part of the loan, or the following transaction. PB enters into a credit derivative with PS, where PB pays a certain premium or spread to PS, say 60 basis points (0.60 per cent) on a value of $100 million (notional value). PS agrees that in the contingency of reference entity suffering defined credit events during the term of the contract, PS will make a certain protection payment to PB. Thereby, PB has shed a part of PB’s exposure in the reference entity to PS; PS has acquired such exposure by selling protection. We will call this transaction a credit default swap, the largest component and really the very standard contract in the credit derivatives market.

A bit of reflection will reveal that PS, selling protection on the reference entity, is taking a credit which is similar to that of a lender to the reference entity. Assume, if PS was to provide actual funding to the reference entity, it would go at a spread of 90 bps. If PS were to actually lend money, it would have to refinance its own balance sheet, say at a cost of 30 bps. In other words, PS is left with a spread of 60 bps, which is exactly what PS gets by selling protection. Thus, selling of protection is an unfunded way of assuming credit exposure. We may say, PS, by selling protection, has synthetically created a credit asset being exposure in reference entity. And for PB, it is a synthetic way of hedging an exposure.

While hedge transactions are the easiest way to understand credit derivatives, the market for credit derivatives is not limited to hedges. In fact, more than majority of trades are not hedges. Credit derivatives are synthetic trades in the credit of the reference entity, as the following discussion shows.

Assume that PB, in our example above, did not have any exposure in the reference entity to begin with. And PB still buys protection, paying a 60 bps premium to PS. The credit spreads on major reference entities are quoted in the credit default swaps market, which is quite a liquid market. Let us suppose the credit quality of the reference entity deteriorates, and therefore, the spreads widen to 75 bps. Now, PB may simply pocket a profit by selling protection in the market at the prevailing rate of 75 bps, making a difference of 15 bps. Likewise, PS has taken a hit as he has sold protection at a price of 60 bps, against prevailing price of 75 bps. In other words, either party may look at the credit derivative transaction as a trade, instead of as a hedge.

As a trading transaction, a credit derivative allows parties to express a view on the credit of the reference entity. PB is expressing a negative or bearish view; PS is expressing a positive or bullish view. We may say, by selling protection, PS has gone long the credit asset; PB has gone short the credit asset. The potential for longing or shorting a particular entity provides exactly similar opportunities as one sees in the equity or bond market. For instance, a trade in equity is a trade in the residual value of a firm. A trade in bonds is also a trade on the credit quality of the firm, sans the residual value. Likewise, credit derivatives are also trades in the credit quality of a firm, which is a product of its asset value. As the value of net assets of an entity increases, the value of equity increases, bond yields fall (as prices increase), and credit default swap spreads narrow down.

There are two extensions of the concept of credit derivatives, index trades and tranched trades. In the market for equities and bonds, investors may acquire exposure to either a single entity’s stocks or bonds, or to a broad-based index.

The logical outcome of the increasing popularity of credit derivatives is credit derivatives indices.

Thus, instead of gaining or selling exposure to the credit risk of a single entity, one may buy or sell exposure to a broad-based index, or sub-indices, implying risk in a generalised, diversified index of names.

The major credit derivative indices in the market are CDX.NA (an index of 125 North American entities); iTraxx Europe (index of 125 European names), iTraxx Asia (index of certain Asian names), etc. As credit derivatives emerged not only with reference to entities but also asset backed securities, there are also indices of credit derivatives on asset backed securities, like ABX.HE (index of certain home equity securitisations), CMBX (index of certain commercial mortgage-backed securitisations), and so on.

The idea of tranching or structured credit trading is essentially similar to that of seniority in the bond market — one may have senior bonds, pari passu bonds, or junior bonds. In the credit derivatives market, this idea has been carried to a much more intensive level with tranches representing risk of different levels. These principles have been borrowed from the structured finance market. Thus, on a bunch of 100 names, one may take either the first 3 per cent risk, or the 3 per cent to 7 per cent slice of the risk, or the 7 per cent to 10 per cent slice, and so on.

The combination of tranching with the indices leads to trades in tranches of indices, opening doors for a wide range of strategies or views to take on credit risk. Traders may trade on the generic risk of default in the pool of names, or may trade on correlation in the pool, or the way the different tranches are expected to behave with a generic upside or downside movement in the credit spreads, or the movement of the credit curve over time, etc.

Quite often, the development of the hedge fund industry has been associated with the development of credit derivatives. Hedge funds are prominent in credit derivatives trades, particularly in case of the lower tranches of the structured credit spectrum. The hedge fund industry represents the segment of investor capital that is least regulated, risk neutral, out to seize opportunities arising out of mispricing, etc. As the credit derivatives trades are almost completely unregulated and offer opportunities of short trades in credit that is difficult to accomplish in the bond market, the credit derivatives industry provides an excellent playing ground to hedge funds.

Apart from credit default swaps and index trades discussed, there is a variety of trades such as total return swaps, swaptions and volatility products. As the market for credit derivatives is highly innovative, structures are invented every now and then.

The sub-prime crisis has affected credit spreads across board; hence people who sold protection about a year ago are having substantial losses. The losses are severe for people who had sold protection on subordinated tranches of the indices. This is the impact of a general movement in credit spreads and does not have anything specific to credit derivatives. Like all structured products are currently being hated, credit derivatives are also being seen with apprehension. However, credit derivatives have allowed an excellent mechanism for players to trade in entities without being affected by the availability of actual financial securities of the issuers. One may acquire global exposures without being constrained by either regulation or availability. One may build a globally diversified book in jiffy. Credit derivatives are here to stay.

(The author is an authority on leasing and an expert on credit derivatives)

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