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UIUC FIN 432 - Credit Derivatives Basic Concepts and Applications

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Credit Derivatives Basic Concepts and Applications by Stephen P. D’Arcy, Department of Finance, University of Illinois James McNichols, Aon Risk Consultants and Xinyan Zhao, Department of Finance, Tianjin University of Finance and Economics Draft 4/9/07 Comments and suggestions would be appreciated. Please send your comments to the first author at [email protected] Please do not copy without the permission of the authors.1 I. INTRODUCTION A credit derivative is a financial instrument that enables one to assume (i.e., take on) or to cede (i.e., reduce) credit risk exposure, primarily to corporate and sovereign debt. Credit risk is transferred with a traded insurance contract, between two parties, neither of which need be the issuer, nor the holder of the actual bonds/loans at risk. The value of the contract is “derived” primarily as a function of the default risk profile of the debtor(s). Credit derivatives are used to express a positive or negative view on a single entity’s (or a portfolio of entities’) credit (i.e., the ability to meet its debt obligations) independent of any other exposures to the entity that one retains. The credit risk element is separate and distinct from the interest rate risk and the funding risk that typically accompanies a short or long cash bond/loan position. Credit derivatives may be used to reduce credit risk arising from ownership of bonds or loans in a manner analogous to that used by property insurers purchasing reinsurance in order to reduce concentrations in their accumulated fortuitous risk from wind storms in Florida, for example. The key innovation of credit derivatives is the ease with which one may trade the credit risk separately from the underlying debt. The global credit derivatives market has grown tenfold in the past four years and is expected to double again over the next few years1. It is notable that in 2006, the $20 trillion notional value2 of credit derivatives globally exceeded the aggregate total face amount of worldwide corporate and sovereign bonds. This accelerated growth was largely driven by increased demand by banks and financial institutions to manage their risk accumulations to corporate and sovereign debt service. This increased demand was initiated by tighter capital management rules promulgated by the Basel II central banking accords. Consequently, credit derivatives have been embraced as a sound risk management tool since they allow the separate pricing of the credit risk component of their overall market risk. 1 Source: British Bankers’ Association Credit Derivatives Report 2006. 2 The notional value is an index on which the performance of the contracts is calculated. Notional value need not be funded and does not change hands, so it is not actually equivalent to the face value of bonds.2 Hedging credit risk accumulations through various capital market options mitigates systemic and material volatility risk to banks earnings and book values. This highlights the very essence of risk management. A pervasive friction is eased and simultaneously the existing market attracts capital from “unrelated” markets. Originators of commercial and consumer loans are aware that they are not always necessarily the best businesses to retain the credit risk from holding others debts over time. Diversification is the key to all risk management strategies and the business of lending and borrowing is no different. In addition to bank demand and diversification of market participants, the tremendous growth of the credit derivatives market has been aided by the fact that credit derivative trades may be unfunded, meaning investors do not make an upfront payment, enabling them to leverage their positions, since investors can buy/sell arbitrarily large positions in a particular credit for reasons of speculation. The subsequent standardization of documentation and the emergence of newer product applications that delve further into sub-risk components of market credit risk (i.e., volatility, recovery rate arbitrage, and correlation) have also fueled the recent expansion of the global credit markets. This expansion has brought about an increase in the credit risk exposures assumed by insurance enterprises, some of which are seeking enhanced underwriting returns, and independent of any credit derivatives trading to effect asset risk hedging strategies. This paper will provide a general overview of credit derivatives and their applications as they emerged primarily as a banking risk management technique and then evolved toward more refined and complex credit risk trading schemes. It will highlight emerging risk areas that will affect actuaries and other financial risk management professionals. II. MARKET PARTICIPANTS The use of credit derivatives is not limited to commercial banks’ risk management departments. Banks and corporations are usually net buyers of credit risk protection,3 while hedge funds, mono-lines, (re)insurance companies, pension funds and mutual funds have emerged recently as significant net sellers of credit risk. Exhibit 1 Total Market Share by Notional Value Year / [Volume in USD bn] 2000 / [$893] 2002 / [$1,952] 2004 / [$5,021] 2006 / [$20,207] 2008 (Est.) / [$33,120] Market Participant Buyers of credit protection Sellers of credit protection Buyers of credit protection Sellers of credit protection Buyers of credit protection Sellers of credit protection Buyers of credit protection Sellers of credit protection Buyers of credit protection Sellers of credit protection Banks – Trading Activities 39% 35% 36% 33% Banks – Loan Portfolio 81% 63% 73% 55% 67% 54% 20% 9% 18% 7% Hedge Funds 3% 5% 12% 5% 16% 15% 28% 32% 28% 31% Pension Funds 1% 3% 1% 2% 3% 4% 2% 4% 3% 5% Corporations 6% 3% 4% 2% 3% 2% 2% 1% 3% 2% Mono-Line Insurers 2% 10% 2% 8% 2% 8% Re-Insurers 3% 21% 3% 7% 2% 4% 2% 4% Other insurance companies 7% 23% 3% 12% 2% 3% 2% 5% 2% 6% Mutual Funds 1% 2% 2% 3% 3% 4% 2% 3% 3% 3% Other 1% 1% 2% 0% 1% 1% 1% 1% 2% 1% Source: British Bankers’ Association Credit Derivatives Report 2006. This table illustrates the relative role of the different participants in the credit derivative market over the past several years and projects a forward forecast, based on the British Bankers Association, the most authoritative source of information on credit instruments.4 Over the last few years,

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