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Contrast the types of credit derivatives, describing what they are used for and what benefits they offer.

FRM® Part I · Foundations of Risk Management · Credit Risk Transfer Mechanisms · FRM1.FR.4.a

The idea

Credit derivatives let a party buy or sell credit risk separately from owning the underlying loan or bond. A credit default swap (CDS) has the buyer pay a periodic premium and receive a payment if the reference entity has a credit event. The payment is Payout = notional × (1 − recovery rate). A total return swap passes on the whole economic return of an asset, so the receiver takes market as well as credit risk. A credit-linked note is funded, because the investor pays principal up front and bears the loss. Credit spread options pay on spread movements without any default. A first-to-default basket pays on the first default among several names, and costs less than the sum of the single-name CDS spreads. Uses are hedging, diversifying and taking views. The usual mistake is to forget that the protection buyer still faces counterparty risk. A CDS also pays only on a defined credit event.

Formulas

CDS payment on a credit event

CDS payment = notional × (1 − R)

notional
the notional amount of protection
R
the recovery rate, as a share of face value

Pays only on a defined credit event. It covers the loss given default, not the whole notional, and the buyer still faces counterparty risk on the seller.

A practice question

From the question bank, with the reason each wrong option is wrong.

A bank bought five-year credit default swap protection on USD 8 million notional of a corporate loan. The reference entity defaults, and the post-default auction values its bonds at 35% of face value. Under cash settlement, the protection payment received by the bank is closest to:

  1. USD 2.8 millionWhy not: Pays the recovery value (35% x 8) instead of the loss, which is notional x (1 - recovery).
  2. USD 5.2 million - correct
  3. USD 8.0 millionWhy not: Pays the full notional, ignoring that the buyer keeps the recovery value of the defaulted debt.
  4. USD 12.3 millionWhy not: Divides the notional by (1 - recovery), 8 / 0.65, instead of multiplying by it.

The CDS pays notional x (1 - recovery rate) = 8 x (1 - 0.35) = USD 5.2 million. The protection covers the loss given default, not the whole notional or only the recovery.

A harder one

A hedge fund enters a one-year total return swap as the total return receiver on a bond with USD 20 million notional. It receives the bond's total return (6% coupon plus price change) and pays a floating rate of 4.5% on the notional. Over the year the bond price falls from 100 to 94. Ignoring compounding and timing, the fund's net cash flow on the swap is closest to:

  1. Receives USD 0.3 millionWhy not: Counts the coupon (1.2) less the floating leg (0.9) but ignores the price decline the receiver must pay.
  2. Receives USD 1.5 millionWhy not: Treats the price fall as a gain to the receiver (1.2 + 1.2 - 0.9) instead of a payment.
  3. Pays USD 0.9 million - correct
  4. Pays nothing, with a net of zeroWhy not: Nets the coupon against the price loss (1.2 - 1.2) and forgets the floating payment of 0.9.

Receiver gets coupon 6% x 20 = 1.2 and pays the price decline 6% x 20 = 1.2 and the floating leg 4.5% x 20 = 0.9. Net = 1.2 - 1.2 - 0.9 = -0.9, so the fund pays USD 0.9 million. A TRS transfers market risk as well as credit risk.

The hardest tier

A bank wants to hedge a loan exposure, is worried about the creditworthiness of whoever provides the protection, and wants the protection to be funded up front. Which structure best meets both aims?

  1. Issuing a credit-linked note to cash investors - correct
  2. Buying single-name CDS protection from a highly rated dealerWhy not: An unfunded contract; the bank remains exposed to the dealer's ability to pay when a default occurs.
  3. Buying a first-to-default basket from a highly rated dealerWhy not: Unfunded and covers only the first default among several names, so it neither funds the protection nor hedges this loan fully.
  4. Entering a total return swap with a dealer as the return payerWhy not: Unfunded and brings back counterparty risk to the dealer, and passes on market risk as well as credit risk.

In a credit-linked note the investor pays the principal at issue, which the bank holds as cash collateral, and the investor is repaid less any credit-event loss. The protection is funded, so seller counterparty risk is largely removed. CDS, basket and TRS contracts are unfunded.

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