25 Янв. 2015 г.|
The credit derivatives industry is expected to be worth over US$7 trillion notional outstanding by 2006. Credit derivatives still account for just slightly more than one percent of the overall market for derivative contracts among commercial banks.
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder. An unfunded credit derivative is one where credit protection is bought and sold between bilateral counterparties without the protection seller having to put up money upfront or at any given time during the life of the deal unless an event of default occurs.
The market in credit derivatives started from nothing in 1993 after having been pioneered by J.P. Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations (see further discussion below). The ISDA reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.
A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. The credit default swap or CDS has become the cornerstone product of the credit derivatives market. In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes. A credit linked note is a note whose cash flow depends upon an event, which may be a default, change in credit spread, or rating change. A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption).
Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults. Credit-linked notes (CLN): Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable.
Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown, Euromoney Handbooks. The striking growth of credit derivatives suggests that market participants find them to be useful tools for risk management. The growth of credit derivatives suggests that market participants find them useful for risk management. All three data sources measure activity in the credit derivatives market with notional amounts. The most comprehensive data source is the BIS Semiannual Derivative Statistics (Bank for International Settlements, 2007). The Joint Forum report, which relied on surveys by Fitch Ratings and Standard and Poor's, also noted that insurance and financial guaranty firms were net sellers of credit protection, along with European banks (Joint Forum, 2005).
Clearly, market participants are finding credit derivatives to be useful tools for risk management to support such rapid growth. Joint Forum (2005), reporting on interviews held in 2004 with about 60 market participants, found that the largest commercial banks had shed a material, but small, amount of credit risk via credit derivatives, mainly to their large, investment-grade corporate customers.
Several reasons could possibly explain why commercial banks appear to be hedging more of their credit risk than they were in 2004.
An investment bank can use credit derivatives to manage the risk it incurs when underwriting securities. New credit derivative instruments appear to have proved useful to underwriters who want to hedge the risk of a residential mortgage loan warehouse. As is typical of successful and liquid new markets, there appears to have been a healthy balance of supply and demand of credit risk in the ABS CDS market.
Now consider an investor who is an "active trader" with a view that over the next three months, Issuer XYZ's credit risk standing will improve and Issuer XYZ's credit spreads will tighten. As mentioned above, one benefit of credit derivatives is that an investor can use credit derivatives to take a customized exposure to particular components of credit risk, such as spread risk, default risk, recovery risk, or correlation risk. To achieve this, suppose that the investor sells $10 million notional amount of credit protection on Issuer XYZ with a 10-year maturity and buys $10 million notional amount of credit protection on Issuer XYZ with a 5-year maturity.
Scenarios 2 and 3 show what happens when Issuer XYZ's credit spread curve narrows or widens at all maturities in a parallel shift.
Without credit derivatives, such a trade would only be possible if Issuer XYZ happened to have bonds outstanding with 5-year and 10-year maturities, and if it was possible to borrow a bond to establish a short position.
Credit index tranches are another example of how credit derivatives can produce different risk-return tradeoffs. Understanding the relative risk of credit index tranches is difficult, but is obviously important for investors who are choosing the risk and return of their investment portfolio.
However, delta only measures one dimension of a tranche's risk, exposure to credit spread risk.
The conclusion from this discussion of the risk of credit index tranches is that, while they broaden the range of risk-return choices that investors have available in the credit markets, they also pose a challenge to understand the various dimensions of risk they are exposed to. The first half of this paper has shown how commercial banks, investment banks, and investors use credit derivatives for managing credit risk. Although credit derivatives cannot eliminate losses from credit risk, they can transform credit risk in intricate ways that may not be easy to understand. However, we can point to evidence from the last credit cycle that some market participants did not fully understand the exposures they had from their participation in the credit derivatives market. This brief review of the experience in the last credit cycle of 2001-02 reinforces the point that credit derivatives do not eliminate losses from credit risk. Given the rapid growth of the credit derivatives market, it may be fortunate that one of the most widely used complex credit derivative structures, the CDO tranche, is a mature product has already been through a stressful credit cycle. Counterparty risk is the risk that the counterparty to a credit derivative contract will default and not pay what is owned under the contract. However, despite the widespread use of collateral and margin, there are some important risk management challenges associated with counterparty risk on credit derivatives. Market participants are aware of the need to measure potential future exposure on complex credit derivatives, as well as the difficulties. Of course, any model is only an approximation of reality, and model improvement must be a continuous process for products as new as tranched credit derivatives. While eventually this research is likely to lead to better models and a reduced level of model risk for complex credit derivatives, there could be a long wait until that occurs. The debate over the role of rating agencies in the market for complex credit derivatives has two sides. On the other side of the debate, it can be argued that the one-dimensional nature of traditional credit ratings makes them insufficient for comparing the risk of corporate debt and structured credit derivatives, and that using the same rating scale for the two is misleading. When an issuer defaults, credit derivatives that reference the issuer's debt must be settled. As the credit derivative market has grown, it is now common for the notional amount of CDS outstanding referencing a particular issuer to be larger than the face value of the issuer's bonds outstanding. Since the growth of the credit derivatives market shows no signs of slowing down, settlement risk is likely to continue to increase as long as physical settlement is the standard in CDS contracts. I have documented the striking growth of credit derivatives, from nearly nothing a decade ago to tens of billions of dollars in notional amounts outstanding at the end of last year. Fitch Ratings (2006), Global Credit Derivatives Survey: Indices Dominate Growth as Banks' Risk Position Shifts, September 21, 2006. However, the overall derivatives market increased less than three-fold from 1997 to 2003, while the credit derivatives market grew nearly sixteen times over. Both claim to be attracting significant liquidity and to be close to getting credit derivative contracts listed on an exchange. Usually these contracts are traded pursuant to an International Swaps and Derivatives Association (ISDA) master agreement. The definition of the relevant credit events must be negotiated by the parties to the note. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. For example a CDO made up of loans is merely a securitizing of loans that is then tranched based on its credit rating. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. An investor, such as an insurance company, asset manager, or hedge fund, can use credit derivatives to align its credit risk exposure with its desired credit risk profile. For the credit derivatives market to continue its rapid growth, market participants must meet these risk management challenges. Notional amounts are often not a good measure of the credit risk that is actually transferred in a particular transaction. About 55 dealers contribute to this survey which breaks out credit derivative notional amounts by the type of counterparty. Some of this captures non-dealer banks investing on their own account in credit derivatives. Firms not reporting to the survey, including hedge funds, asset managers, and pension funds, must be shedding this $377 billion of notional credit risk. The amount of credit risk shed by banks may be rising, and hedging has spread to categories of credit risk beyond investment-grade corporate loans.
An underwriter assumes credit risk for the short time between when it takes the risk on its own books and when it sells the risk into the market. One way for underwriters to cope with such a potential increase in credit risk is to hedge more of it. Beginning in mid-2004, dealers began to trade credit default swaps on asset-backed securities (referred to as ABS CDS).
An investor can use credit derivatives to align its credit risk exposure with its desired credit risk profile. The advantages of credit derivatives as a risk management tool are different for the two groups.
This investor can shift its exposure away from telecom issuers by buying credit protection on telecom issuers using credit default swaps. To replace the telecom exposures, this investor can sell credit protection on other, non-telecom issuers, or simply sell credit protection on a credit default swap index. However, buying a bond or selling credit protection exposes the investor to the risk that Issuer XYZ defaults, which may be a risk the investor does not want to take. As expected, in scenario 2, the issuer gains on net when the credit spread narrows, and the opposite occurs in scenario 3 when the credit spread widens. A credit index such as CDX (in North America) or iTraxx (in Europe) is a liquid product that provides exposure to a broad segment of the credit derivatives market. Clearly, no one should be surprised if when the credit cycle turns, the speculative grade default rate hits 10 percent, which is what it hit in 1990-91 and in 2001.
But where complex credit derivatives such as CDO tranches are concerned, it is a legitimate risk management issue. Given the breadth of market participants who are active in the credit derivative market, there is no definitive way to answer this question. Credit risk would have manifested itself in a decline in the mark-to-market value of such a tranche. Given the slowing growth of house prices in recent months, credit risk in the RMBS sector is likely to be increasing.
For credit derivatives, as with other OTC derivatives, counterparty risk is an important risk that needs to be managed. According to the 2006 ISDA Margin Survey, 63 percent of all counterparty risk exposure on credit derivatives is currently collateralized by large dealers. And of course, any counterparty credit exposure amount should be compared with a dealer's capital that is available to absorb potential losses.8 All told, it appears that counterparty risk should be a material concern of participants in the credit derivatives market. While a few complex credit derivatives, such as credit index tranches, are traded in liquid markets with some price transparency, most are not.
As noted in a recent central bank research report, the structured finance market, including the credit derivatives market, relies heavily on ratings (Committee on the Global Financial System, 2005). This should discourage investors from treating an AAA rating on a structured credit derivative exactly like an AAA rating on a corporate bond. Without taking a stand on which risk measure is better or worse, it seems clear that relying on a rating to tell the entire story of the risk on a tranched credit derivative product is a bad idea. For the credit derivatives market to develop and mature, market participants must address these risk management challenges. While the asset-backed securities market includes securities backed by a range of collateral, including credit card loans and auto loans, nearly all ABS CDS contracts reference RMBS or commercial mortgage-backed securities. One example of such a report appeared in Risk magazine in September 2004: "By autumn 2002, all the talk in the structured credit community was about restructuring.
This particular securitization is known as a collateralized loan obligation (CLO) and the investor receives the cash flow that accompanies the paying of the debtor to the creditor. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation.
Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. Notional amounts of credit derivatives outstanding have roughly doubled each year for the past five years. Credit derivatives can be more flexible and less expensive than transacting in cash securities. As a result, when the credit cycle turns and default rates rise, someone, somewhere, will lose money. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
A CDO only becomes a derivative when it is used in conjunction with credit default swaps (CDS), in which case it becomes a Synthetic CDO. The main difference between CDO's and derivatives is that a derivative is essentially a bilateral agreement in which the payout occurs during a specific event which is tied to the underlying asset.