Managing Credit Risk

This ability of structured finance to repackage risks and create safe assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. - !oshua "aval , !akub !urek, #rick $tafford.

Introduction
Credit risk arises from the possibility of default by counterparty. Credit risk lay at the heart of the sub prime crisis. The most important point to note about credit risk is that it is more difficult to model and measure compared to market risk. Unlike market risk, where a lot of data is available in the public domain, data is scanty and sometimes non existent in case of credit risk. Moreover, credit risk is far more contextual, i.e., firm specific compared to market risk. Despite these challen es, there has been si nificant pro ress in credit risk modelin in recent years. !n this chapter, we will examine the three buildin blocks of credit risk mana ement " probability of default, exposure at default and recovery rate. #e will also discuss briefly some of the commonly used credit risk modelin techni$ues. These techni$ues can help us to estimate the potential loss in a portfolio of credit exposures over a iven time hori%on at a specified confidence level. The aim of this chapter is to provide a hi h level understandin of credit risk mana ement.

Pre-settlement and Settlement risk

Credit risk can be defined as the likelihood of a counterparty failin to dischar e its obli ations. &ny credit transaction typically involves two sta es' pre settlement and settlement. %re-settlement risk refers to the probability of failure of the counterparty to dischar e its obli ation durin the life of the transaction. This includes the possibility of defaultin on bond interest or principal repayment or not makin mar in payment in case of a derivative transaction. $ettlement risk arises at the time of maturity. (uppose a bank fulfils its obli ation at the time of expiry of a contract. Till the time the bank receives its dues from the counterparty, settlement risk exists. & ood example of such risk is forei n currency payments made by two parties in different time %ones. To deal with settlement risk, banks have developed real time gross settlement systems. (uch systems reduce the time interval between the point a stop payment instruction can no lon er be made and the point of receipt of dues from the counterparty. &nother techni$ue used is netting. !nstead of payin the ross amounts to each other, only the net
)

*The +conomics of (tructured ,inance,- .arvard /usiness (chool, #orkin 0aper, 12-131, 4115.

4 amount is paid by one of the counterparties. This reduces the exposure and contains the dama e even if thin s o wron . 6$ee box item& 'anaging settlement risk at ()$*
Settlement risk at UBS (ettlement risk arises in transactions involvin exchan e of value when U/( must honor its obli ation to deliver without first bein able to determine that the counter-value has been received. !n 4115, settlement risk on 758 of ross settlement volumes was eliminated throu h risk miti ation. The most si nificant source of settlement risk is forei n exchan e transactions. U/( is a member of Continuous 9inked (ettlement 6C9(:, a forei n exchan e clearin house which allows transactions to be settled on a delivery versus payment basis. The proportion of U/(;s overall ross volumes settled throu h C9( increased to <<8 durin 4115 compared to <=8 in 4117. The avoidance of settlement risk throu h C9( and other means does not, of course, eliminate the credit risk on forei n exchan e transactions resultin from chan es in exchan e rates prior to settlement. (uch counterparty risk on forward forei n exchan e transactions is measured and controlled as part of the overall credit risk on >TC derivatives. $ource& U/( &nnual ?eports, 4115.

Probability of default
The probability of default is a key concern in credit risk mana ement. Two kinds of factors must be evaluated to arrive at the probability of default " borrower specific and market specific. /orrower specific factors include' collateral levera e volatility of earnin s@cash flows reputation. Market specific factors include' the phase of the business cycle industry conditions interest rates exchan e rates Exhibit !" S#P$s Cor%orate &inance Cumulati'e (efault Rates ")*"-+,,* -./

=
+ef' The Turner ?eview - & re ulatory response to the lobal bankin crisis, published by' UA ,inancial (ervices &uthority, www.fsa. ov.uk@pubs@other@turnerBreviewC March 4112

Illustration & portfolio consists of < bonds each with a probability of default of .1). #hat is the probability that there will be no defaultD #hat is the probability that there will be at least one defaultD #hat is the probability of exactly one defaultD #hat is the probability of exactly two defaultsD 0robability of no default 0robability of at least one default 0robability of exactly one default 0robability of exactly two default E E E E 6.22:< ) - .2<) <C) 6.22:F 6.1): <C4 6.22:= 6.1):4 E E E E .2<) .1F2 .1F51 .11127

Illustration The cumulative probability of default of an instrument over two years is <8. The probability of default in the first year is 48. #hat is the probability of default in the second yearD 0robability of no default over the two years E ) - 1.1< E 1.2< 0robability of no default durin the first year E 1.25 9et probability of default in the second year be p !n order that there is no default over the two years, there must be no default at in year ) or year 4. Then 6.25: 6)-p: E .2< p E E
) .2< .25

1.1=13

(o probability of default'

=.138

0raditional methods
Default risk models can ran e in complexity from simple $ualitative models to hi hly sophisticated $uantitative models. 9et us look first at some of the more simple and traditional ways of estimatin the probability of default. These typically use financial statement data. Then we will examine some of the more sophisticated models.

1ltman$s 2 Score
&ltman;s4 G score is a ood example of a credit scorin tool based on data available in financial statements. !t is based on multiple discriminant analysis. The G score is calculated as' , E ).4x) H ).Fx4 H =.=x= H 1.3xF H .222x< x) E #orkin capital @ Total assets x4 E ?etained earnin s @ Total assets x= E +arnin s before interest and taxes @ Total assets xF E Market value of e$uity @ /ook value of total liabilities
4

. +.! &ltman, *,inancial ?atios, Discriminant &nalysis and the 0rediction of Corporate /ankruptcy,!ournal of -inance, (eptember )235, pp. <52-312

F x< E (ales @ Total assets >nce G is calculated, the credit risk is assessed as follows' G I =.1 means low probability of default 4.7 J G J =.1 means an alert si nal ).5 J G J 4.7 means a ood chance of default G J ).5 means a hi h probability of default

6(afe %one: 6Krey %one: 6Krey %one: 6Distress %one:

& variant of the &ltman score has been used in the case of mort a e loans in the U(. This is called the ,!C> score. ,!C> scores are tabulated by independent credit bureaus usin a model created by ,air !ssac Corporation 6,!C>:. & lower ,!C> score denotes a hi her risk of default and vice versa. !n mid-4117, the avera e ,!C> scores were 74<, 7=2, 7)4 and 345 for a ency=, Lumbo, &lt-& and sub prime mort a es.

Estimating %robability of default from market %rices

The problem with financial statements is that they tend to be backward lookin . & simple but forward lookin way to measure the probability of default is to examine the market prices of bonds which are traded. (uppose the one year T /ill yields 48 while a one year corporate bond yields =8. &ssume that no recovery is possible in case of a default, what is the probability of defaultD #e can invest in either the T /ill or the risky instrument. 9et us say we make an investment of M) for exactly one year. !f we assume the probability of default is p, the followin e$uation must hold ood' ).14 E ).1= 6)-p: !f this e$uation does not hold, arbitra e is possible by oin lon in one of the instruments 6which fetches hi her return: and short in the other 6which fetches lower return:. (olvin we et' p E )
6).14: 6).1=:

E E

.1127 .278

(uppose in the earlier illustration, the recovery in the case of default has been estimated as <18. This means that in the case of default, <18 of the exposure can be recovered. Then we can rewrite the e$uation as follows' ).14 E 6).1=: 6)-p: H 6).1=: 6p: 6.<: E ).1= " ).1=p H .<)< p .<)< p E .1) p E .1)2F E ).2F8

. & ency mort a es are backed by ,annie Mac@,raddic Mac. Numbo mort a es as the name su ests are lar e loans. 9imited documentation is the key feature of &lt-& loans. (ubprime mort a es have the hi hest probability of default. ,or more details, see Chapter =.

< More enerally, let i be the yield of the risky bond, r that of the risk free instrument. 9et p be the probability of default and f the recovery rate, i.e., fraction of the amount which can be collected from the debtor in case of a default. Then for a loan of value, ), to prevent arbitra e, the followin condition must hold' )Hr E 6)Hi* 6)-p* H 6)Hi: pf or )Hr E ) H i " p " pi H pf Hipf or i . r / p 0 pi . pf . ipf. ! norin pi, ipf, as these will be small $uantities, we et' i - r / p 1 -f*. (ince f is the recovery rate, 6)-f: is nothin but the loss iven default. 6 i . r* is the credit spread. Thus the spread or risk premium e2uals the product of the default probability and the loss given default. There is nothin surprisin about the result. (ince we have assumed the loan value to be ), the left side of the e$uation is the excess amount received by investors for the risky loan in comparison to a risk free loan and the ri ht side is the expected loss on the risky loan. !n other words, the left side represents the risk compensation to the investor and the ri ht side, the expected loss. To prevent arbitra e, the risk compensation must e$ual the expected loss.
Measuring Probability of default at UBS U/( assesses the likelihood of default of individual counterparties usin ratin tools tailored to the various counterparty se ments. & common Masterscale se ments clients into )< ratin classes, two bein reserved for cases of impairment or default. The U/( Masterscale reflects not only an ordinal rankin of counterparties, but also the ran e of default probabilities defined for each ratin class. 6(ee +xhibit 3.4: Clients mi rate between ratin classes as U/(;s assessment of their probability of default chan es. +xternal ratin s, where available, are used to benchmark U/(;s internal default risk assessment. The ratin s of the maLor ratin a encies are linked to the internal ratin classes based on the lon -term avera e )-year default rates for each external rade. >bserved defaults per a ency ratin cate ory vary year-onyear, especially over an economic cycle. (o U/( does not expect the actual number of defaults in its e$uivalent ratin band in any iven period to e$ual the ratin a ency avera e. U/( monitors the lon -term avera e default rates associated with external ratin classes. !f these lon -term avera es chan e in a material and permanent way, their mappin to the Masterscale is adLusted. &t the !nvestment /ank, ratin tools are differentiated by broad se ments - banks, soverei ns, corporates, funds, hed e funds, commercial real estate and a number of more speciali%ed businesses. The desi n of these tools follows a common approach. The selection and combination of relevant criteria 6financial ratios and $ualitative factors: is determined throu h a structured analysis by credit officers with expert knowled e of each se ment, supported by statistical modelin techni$ues where sufficient data is available. The (wiss bankin portfolio includes exposures to a ran e of enterprises, both lar e and small- to mediumsi%ed 6*(M+s-: and the ratin tools vary accordin ly. ,or se ments where sufficient default data is available, ratin tool development is primarily based on statistical models. Typically, these *score cardsconsist of ei ht to twelve criteria combinin financial ratios with $ualitative and behavioral factors which have proven ood indicators of default in the past. ,or smaller risk se ments with few observed defaults, a more expert based approach is chosen, similar to that applied at the !nvestment /ank. ,or the (wiss commercial real estate se ment, which is part of the retail se ment, the probability of default is derived from simulation of potential chan es in the value of the collateral and the probability that it will fall below the loan amount. Default expectations for the (wiss residential mort a e se ment are based on the internal default and loss history, where the maLor differentiatin factor is the loan to value ratio " the amount of the outstandin obli ation expressed as a percenta e of the value of the collateral. $ource& U/( &nnual ?eports

<

Exhibit !+

$ource& U/( &nnual ?eport - 4115

Illustration Calculate the implied probability of default if the one year T /ill yield is 28 and a one year %ero coupon corporate bond is fetchin )<.<8. &ssume recovery in the event of default is %ero. 9et the probability of default be p +xpected returns from corporate bond E ).)<< 6)-p: H 61: 6p: +xpected returns from treasury E ).12 or ).)<< 6)-p: E ).12 p E ) - ).12@).)<< E .1<3= E <.3=8 Illustration !n the earlier problem, if the recovery is 518 in the case of a default, what is the default probabilityD ).)<< 6)-p: H 6.51: 6).)<<: 6p: or .4=) p or p E E E E ).12 1.13< 1.45)F 45.)F8

7
1 brief note on Credit Rating 1gencies3 ?atin a encies speciali%e in evaluatin the creditworthiness of debt securities and also the eneral credit worthiness of issuers. The ratin iven by the a encies are a ood indication of the likelihood of all interest payment and principal repayments bein made on time. #here capital markets have replaced banks as the maLor source of debt capital, ratin a encies have a particularly important role to play. /asle !! refers to the credit ratin a encies as external credit assessment institutions. The three main ratin a encies in the U( are Moody;s (tandard and 0oor;s and ,itch. The ori in of ratin a encies in the U( oes back to )212 when Nohn Moody initiated bond ratin s for the rail roads. !n )234, Dun and /radstreet ac$uired Moody;s &fter flourishin till the )2=1s, ratin a encies be an to stru le as the bond markets were reasonably safe, dominated by overnment debt and investment rade corporates. /ut in the )271s, the debt markets became more volatile, a landmark event bein the bankruptcy of 0enn Central in )271. !n the )271s, the ratin a encies also revamped their revenue model, movin away from subscription payin investors to fee payin issuers. The a encies also widened the scope of covera e to include asset backed securities, commercial paper, municipal bonds, insurance companies, etc. &s credit $uality can chan e over time, ratin a encies publish updates on issuers at periodic intervals. #hile issuin ratin s, the a encies can indicate whether the outlook is positive, i.e., it may be raised, ne ative, i.e., it may be lowered or stable, meanin neutral. The revenue model of ratin a encies remains a source of concern. The independence of ratin a encies and their role durin the sub prime crisis has been $uestioned. The !nternational or ani%ation of (ecurities Commissions 6!>(C>: published a code of conduct for the ratin a encies in December 411<. #hile ratin bonds, the ratin a encies consider various factors. (O0 for example looks at the followin while ratin bonds' /usiness risk !ndustry characteristics Competitive positionin Mana ement ,inancial risk ,inancial characteristics ,inancial policies 0rofitability Capitali%ation Cash flow protection ,inancial flexibility The a encies compute a number of financial ratios and track them over time. The a encies typically study a ran e of public and non public documents related to the issuer and the specific debt issue. They review the accountin practices. Meetin s are usually held with the mana ement to seek clarifications re ardin key operatin and financial plans and policies. (ome amount of subLectivity in the ratin process, however, cannot be avoided. ,ollowin the sub prime crisis, the ratin a encies have been revisitin the default and loss assumptions, in their models. They have also been reviewin the assumptions made about correlations across asset classes. The a encies maintain that their approach is transparent. They also swear by their independence. The a encies, however, have acknowled ed that there have been problems with the $uality of information.
F

Nohn / Caouette, +dward ! &ltman, 0aul Parayanan and ?obert # N Pimmo, *Mana in Credit ?isk " The reat challen e for lobal financial markets,- Nohn #iley O (ons, 4115.

5
They have also acknowled ed the need to o beyond ability to pay, to include other factors such as li$uidity. #hile the role of the ratin a encies is under intense scrutiny, they will continue to play a maLor role in the capital markets. The a encies, provided they can reinvent themselves, may still provide a transparent, independent and affordable institutional framework for evaluatin credit risk.

Ex%osure at default
Pow that we have covered probability of default, it is time to move on to the second buildin block of credit risk mana ement " credit exposure. &t the time of default, the amount of exposure determines the extent of losses. The lar er the exposure, more the losses. (o alon with the probability of default, we must also determine the amount of exposure. The amount of credit exposure at the time of default is called exposure at default 6+&D:. !n traditional bankin , the exposure is usually the face value of the loan. /ut when derivatives and structured products are involved, the face value is not the relevant parameter. Determinin the exposure is a more involved process. Kuarantees and commitments further complicate the problem. !n case of derivative contracts, three situations may arise. The contract may be a liability to the bank, an asset to the bank or either of the two. #here the derivative position is a liability, there is no credit exposure. #hen the derivative position is an asset, there is credit exposure. !n the third case, the position can be an asset or a liability dependin on the market fluctuation. (o there is a possibility of loss when the position is an asset and no loss when the position is a liability. Credit exposure can be broken down into two components " current exposure and potential exposure. Current exposure is the exposure which exists today. 0otential exposure is the likely exposure in case the credit deteriorates. &dLusted exposure takes into account both current and potential exposure.

Credit exposure can be mana ed proactively in various ways. /y markin to market, any variations in the position can be settled daily, throu h a mar in account, instead of allowin an accumulation over the life of the contract. Collateral also helps a company to protect itself a ainst current and potential exposure. The collateral will typically exceed the funds owed, by an amount called haircut. Down rade tri ers can also be used to modify exposure. & clause can be inserted statin that if the credit ratin of the counterparty falls below a certain level, the bank has the option to close out the derivatives contract at its market value.
Ex%osure at default at UBS +xposure at default represents the amounts U/( expects to be owed at the time of default. ,or outstandin loans, the exposure at default is the drawn amount or face value. ,or loan commitments and for contin ent

2
liabilities, it includes any amount already drawn plus the additional amount which is expected to be drawn at the time of default, should it occur. ,or traded products, the estimation of exposure at default is more complex, since the current value of a contract can chan e si nificantly over time. ,or repurchase and reverse repurchase a reements and for securities borrowin and lendin transactions, the net amount is assessed, takin into account the impact of market moves over the time it would take to close out all transactions 6*close-out exposure-:. +xposure at default on >TC derivative transactions is determined by modelin the potential evolution of the replacement value of the portfolio of trades with each counterparty over the lifetime of all transactions " *potential credit exposure- " takin into account le ally enforceable close-out nettin a reements where applicable. ,or all traded products, the exposure at default is derived from a Monte Carlo simulation of potential market moves in all relevant risk factors, such as interest rates and exchan e rates. The randomly simulated sets of risk factors are then used as inputs to product specific valuation models to enerate valuation paths, takin into account the impact of maturin contracts and chan in collateral values, includin the ability to call additional collateral. The resultant distribution of future valuation paths supports various exposure measures. &ll portfolio risk measures are based on the expected exposure profile. /y contrast, in controllin individual counterparty exposures, U/( limits the potential *worst case- exposure over the full tenor of all transactions, and therefore applies the limits to the *maximum likely exposure- enerated by the same simulations, measured to a specified hi h confidence level. Cases where there is material correlation between factors drivin a counterparty;s credit $uality and the factors drivin the future path of traded products exposure " *wron -way risk- " re$uire special treatment. !n such cases, the potential credit exposure enerated by the standard model is overridden by a calculation from a customi%ed exposure model that explicitly takes this correlation into account. $ource' U/( &nnual ?eport

4oss gi'en default

The third buildin block of credit risk mana ement is the loss iven default. !n case of a default, it may be possible to recover part of the amount owed. The proportion of the amount which cannot be recovered is called loss given default. The amount which can be recovered depends on various factors. The first factor is seniority. (enior claims have priority while settlin claims. Thus secured bonds have priority over unsecured ones. The ease, with which assets can be sold to recover the amounts due, depends on the le al system and bankruptcy procedures. Collaterali%ation i.e., the amount of collateral backin the loan, is another key factor in determinin the recovery rate. ?ecovery rates are also more si nificantly ne atively correlated with default rates. & bad year for defaults is also bad for recovery. /efore we take up a couple of simple illustrations, we need to define a few terms. & commitment represents the total amount the bank is prepared to lend to the borrower. >n the other hand, outstandings refers to the actual amount loaned. Thus the commitment consists of two components " the outstandin and the unused portion of the commitment. The undrawn portion is nothin but a borrower;s call option to draw on the full credit line in distress. Durin distress, the borrower will indeed draw on the remainin amount,

)1 fully or partly. The &dLusted exposure is nothin but the prior exposure adLusted for this drawdown. &dLusted exposure is calculated takin into account the bank;s total commitment, undrawn amount and the likely draw down in the case of credit deterioration. /anks of course may put in place covenants that limit such drawdowns.

Ex%ected and unex%ected loss

#xpected loss is the avera e loss in value over a period of time for a iven exposure. The expected loss is best handled by buildin it into the product price. The unexpected loss refers to the variability of potential loan loss around the avera e loss level. The unexpected loss can be viewed as some multiple of the standard deviation of the expected loss. The essence of credit risk management is arriving at a good estimate of the unexpected loss. The unexpected loss in turn can be divided into two components. The statistical losses can be measured usin techni$ues such as Q&?. 3osses in the tails can be estimated by stress testin or by applyin extreme value theory.

+xpected losses

(tatistical losses

(tress losses

4oss gi'en default at UBS 9oss iven default represents U/(;s expectation of the extent of loss on a claim should default occur. 9oss iven default includes loss of principal, interest and other amounts due and also the costs of carryin the impaired position durin the work-out process. !n the !nvestment /ankin roup, loss iven default estimates are based on expert assessment of the risk drivers 6country, industry, le al structure, collateral and seniority:, supported by empirical evidence from internal loss data and external benchmark information where available. !n the (wiss portfolio, loss iven default differs by counterparty and collateral type and is statistically estimated usin internal loss data. ,or the residential mort a e portfolio, further distinctions are achieved by statistical simulation based on loan to value ratios. $ource' U/( &nnual ?eport

)1

)) Exhibit !5 Ex%osure to credit risk at UBS

$ource' U/( &nnual ?eport, 4115

Exhibit !3

$ource' U/( &nnual ?eport, 4115

Ca%turing correlations6 Structural and Reduced &orm Models

(o far we have considered simple situations. !n reality, banks face multiple exposures. Correlations may exist amon different exposures. ,or example, there tends to be hi her default rates across all ratin s rades durin a recession. To capture correlations amon different credit events, there are broadly two approaches' $tructural models and +educed form models.

))

)4 (tructural models try to establish a relationship between default risk and the value of the firm. ,or example, e$uity prices can be used to estimate the probability of default of the bond of a company whose shares are listed on the stock exchan e. !n structural models, debt and e$uity are viewed as contin ent claims on firm value. The probability of default is calculated from the difference between the current value of the firm;s assets and liabilities and the volatility of the assets. (tructural models are difficult to apply if the capital structure is complicated or if the assets are not traded. (tructural models view a firm;s e$uity as an option on the firm;s assets with a strike price e$ual to the value of the firm;s debt. >ption pricin models, typically, /lack-(choles are used to identify the fair value of these claims. Two approaches are cited in the literature. The first was developed by the Pobel pri%e winnin economist, ?obert Merton. The second, called AMQ is a modification of Merton;s model by the credit ratin company, Moody;s. 9et us briefly examine these two models.
Merton Model

The value of a firm, Q e$uals the sum of the values of debt, D and e$uity, +. The Merton model attempts to measure the value of D and thus forecast the probability of default. The model frames the situation in such a way it reduces to an option pricin problem. The key assumption in the Merton model is that the firm has made a sin le issue of %ero coupon debt that will be paid back in one shot, at a future point in time. >ther assumptions include perfect financial markets, no bankruptcy costs and no costs to enforce contracts. &ll these assumptions can be suitably modified to extend the Merton Model. 9et us use the followin notations' Q> QT +> +T D Q + T E E E E E E E E Current value of the company;s assets. Qalue of the company;s assets at time T. Qalue of the company;s e$uity today. Qalue of the company;s e$uity at time T. &mount of %ero coupon debt maturin at time T. Qolatility of assets. Qolatility of e$uity. Time of maturity of the debt.

Two situations can arise. !f QT J D, the company will default on its debt. Debt holders will receive QT. +$uity holders will not receive any thin , i.e., +T E 1. !f QT I D, debt holders will receive their full payment, D. +$uity holders will receive Q T " D. #e can now combine the two possibilities into a more enerali%ed e$uation' +T E max 6QT " D, 1:

)4

)= &s the minimum value of e$uity is 1 and the maximum value is unlimited, the pay off profile is that of a call option with strike price E D. #e can now apply the /lack (choles model to value the e$uity. +> E Q1 P 6d): " De-rt P 6d4:

d) d4

E E

l n651 @ 4: + 6r + v @ 4:T v T
4

d) - vT

P refers to the cumulative normal probability. The probability of default on the debt is P 6-d4:. To calculate d4, we need to know the value of Q 1 and v. /oth fi ures will in eneral not be readily available. (o, assumin the company;s shares are listed, we have to start with +1. There is a relationship available based on !to;s lemma. 6Derivation of this relationship is beyond the scope of this book.: + +1 E
d# v Q1 d5

Usin this relationship we can estimate Q1 and v. #e could also approach the problem in a different way by statin that the amount received by the debt holders of the company is' D " Max R6D-QT:, 1S. D is the pay off obtained by investin in a risk free %ero coupon bond maturin at time T with a face value of D. The second term, - Max TD-QT, 1U is the pay off from a short position in a put option on the firm;s assets with strike price, D and maturity date, T. /y subtractin the value of the put from the risk free debt, we can value risky debt. The value of the put can be calculated by applyin the /lack-(choles formula' 0 E De-r6t: P 6-d4: " Q1P6-d):

)=

)F Illustration #hat is the value of a firm;s e$uity if the total value of the firm is M311 million and the debt repayment is M)11 millionD #hat will be the value of e$uity if the total value of the firm drops to M7< millionD !n the first case, value of e$uity !n the second case, value of e$uity total firm value. E E 311 " )11 E M<11 million 1 as the value of debt repayment exceeds the

Illustration The market value of a firm is M31 million and the value of the %ero coupon bond to be redeemed in = years is M<1 million. The annual interest rate is <8 while the volatility of the firm value is )18. Usin the Merton Model, calculate the value of the firm;s e$uity. 9et us first calculate the curent firm value, (. ( E 31 x P 6d): " 6<1:e-6.1<:6=: x P 6d4: 31 .)1 4 ln + 6.1< + :6=: d) E <1 4 .)1 = E d4 ( E E E E E E
.)54= +.)3< .)7=4)

4.11< d) - t E 4.11< " 6.):6=: E 4.11< - .)7=4) 31 P 64.11<: " 6<1: 6.5317: P 6).5=)5: 31 P 64.11<: " 6F=.1=<: P 6).5=)5: 631: 6.277<: " 6F=.1=<: 6.233<: M)7.1<7 million

E ).5=)5

#e can now calculate the current value of the firm;s debt. Dt E E E De-r6t: " pt <1e-.1<6=: " pt F=.1=< " pt

/ased on put call parity 0t E Ct H ,e-r6t: " Q >r 0t E )7.1<7 H F=.1=< " 31 Dt E F=.1=< - .124

E E

.124 MF4.2F= million

#e can verify our calculation by addin up the market values of debt and e$uity and notin that we et the market value of the firm.

)F

)<
7M8 Model

Moody;s AMQ approach adLusts for some of the limitations of the Merton model. The Merton Model assumes that all debt matures at the same time and the value of the firm follows a lo normal diffusion process. The AMQ model assumes that there are only two debt issues. The first matures before the chosen hori%on and the other matures after that hori%on. The AMQ model uses a concept called distance to default. This is defined as the number of standard deviations by which the asset price must chan e in order for a default to happen in T years. The distance to default can be calculated as' ln51 ln4 + 6r v4 @ 4:T v T ,rom the formula we can see that this is nothin but the value of d 4 in the /lack (choles formula. The distance to default is a proxy measure for the probability of default. &s the distance to default decreases, the company becomes more likely to default. &s the distance to default increases, the company becomes less likely to default. The AMQ model, unlike the Merton Model does not use a normal distribution. !nstead, it assumes a proprietary al orithm based on historical default rates. Usin the AMQ model involves the followin steps' a: !dentification of the default point, D. b: !dentification of the firm value Q and volatility . c: !dentification of the number of standard deviation moves that would result in the firm value fallin below D, thereby leadin to default. This is the firm;s distance to default, V. d: ?eference to the AMQ database to identify the proportion of firms with distanceto-default, V who actually defaulted with a year. This is the expected default fre$uency. AMQ takes D as the sum of the face value of the all short term liabilities 6maturity J ) year: and <18 of the face value of lon er term liabilities. Illustration Consider the followin fi ures for a company. #hat is the probability of defaultD /ook value of all liabilities +stimated default point, D Market value of e$uity Market value of firm Qolatility of firm value ' ' ' ' ' M4.F billion M).2 billion M)).= billion M)=.5 billion 418

#e first calculate the distance to default. Distance to default 6in terms of value: (tandard deviation E E )=.5 " ).2 6.41: 6)=.5:
)).2 4.73

E E E

M)).2 billion M4.73 billion F.=)

Distance to default 6in terms of standard deviation: E

)<

)3

#e now refer to the default database. !f = out of )11 firms with distance to default of F.=) actually defaulted, probability of default is .1= Illustration Kiven the followin fi ures, compute the distance to default' /ook value of liabilities +stimated default point Market value of e$uity Market value of firm Qolatility of firm value ' ' ' ' ' M<.2< billion MF.)< billion M )4.F billion M)5.F billion 4F8 E E )5.F " F.)< 6.4F: 6)5.F:
)F.4< F.F)3

Distance to default 6in terms of value: (tandard deviation

E E

M)F.4< billion MF.F)3 billion E =.4=

Distance to default 6in terms of standard deviation:

!f in the default database, 4 out of )11 firms with a distance to default of =.4= actually defaulted, the probability of default is .14.

Reduced form models

These models assume that default events occur unexpectedly due to one or more exo enous back round factors which are independent of the firm;s asset value. These factors may be observable such as KD0 rowth, interest rates, exchan e rates, inflation or unobservable. Correlations arise because these back round factors affect all the exposures. ?educed form models typically assume that default follows a 0oisson distribution or similar ha%ard rate process. Usin the 0oisson distribution, we can determine the number of default events occurrin durin a specified period of time.

Credit Risk models

Credit risk models are used by banks to calculate the credit loss for a iven time hori%on. The output of these models is a portfolio loss distribution which describes the potential credit losses and their probabilities. & credit loss is nothin but a decrease in the value of a portfolio over a specified period of time. To estimate credit loss, we need to establish the portfolio value today and at the end of the time hori%on. There are two conceptual approaches to measurin credit loss. !n the default mode paradigm, a credit loss occurs only when there is an actual default. The credit loss is nothin but the difference between the exposure-at-default and the recovery value. !n the mark-to-market paradigm a credit loss occurs if the borrower defaults or if the borrower;s credit $uality deteriorates. To measure the value of the obli ations, two techni$ues are commonly used " discounted contractual cash flow approach and risk neutral valuation approach. !n the first approach, the credit spreads are used to discount cash flows. Chan es in the value of the loan are the result of chan es in market spreads or chan es in credit ratin . !n case of a

)3

)7 default, the future value is determined by the recovery rate. !n risk neutral valuation, we apply risk free rates and risk neutral probabilities.
Credit Risk Plus

The lobal bank, Credit (uisse< has developed a model for estimatin default probability and Qalue at ?isk. This model, called Credit ?isk 0lus, is based on actuarial, analytical techni$ues and does not use simulation. Credit risk is modeled on the basis of sudden events. Default rates are treated as continuous random variables. (uppose there are 6 counterparties of a type and the probability of default by each counterparty is p. !f we consider that there are only two possibilities " default or no default and apply the binomial distribution, the mean number of defaults, , for the whole portfolio is Pp. !f p is small, the probability of n defaults is iven by the 0oisson distribution, i.e, the followin e$uation' p 6n: E
e n nW

The next step is to specify the recovery rate for each exposure. Then the distribution of losses in the portfolio can be estimated. Credit ?isk H allows only two outcomes " default and no default. !n case of default, the loss is of a fixed si%e. The probability of default depends on credit ratin , risk factors and the sensitivity of the counterparty to the risk factors. >nce the probability of default is computed for all the counterparties, the distribution of the total number of defaults in the portfolio can be obtained. #hen the probability of default is multiplied successively by exposure at default and loss iven default, we et the credit loss. Throu h the use of sector analysis, Credit ?isk 0lus can measure the impact of concentration risks and the benefits which can be obtained throu h diversification.
Credit Metrics

Credit Metrics, another popular model, has been developed by N 0 Mor an. Unlike Credit ?isk 0lus, this model does not view credit risk as a binary situation. !nstead, Credit Metrics tries to determine the probability of a company movin from one ratin cate ory to another durin a certain period of time. Credit Metrics first estimates the ratin class for a debt claim. The ratin may remain the same, improve or deteriorate, dependin on the firm;s performance. & ratin s transition matrix, usually provided by the ratin a encies, ives us the probability of the credit mi ratin from one ratin to another durin one year.

<

The subsidiary of Credit (uisse, Credit (uisse ,irst /oston pioneered this model.

)7

)5 Exhibit !9 4argest CR1s :lobal Structured &inance " ;ear 0ransition Rates

+ef' The Turner ?eview - & re ulatory response to the lobal bankin crisis, published by' UA ,inancial (ervices &uthority, www.fsa. ov.uk@pubs@other@turnerBreviewC March 4112.

Pext, we construct the distribution of the value of the debt claim. #e compute the value we expect the claim to have for each ratin in one year. /ased on the term structure of bond yields for each ratin cate ory, we can et today;s price of a %ero coupon bond for a forward contract to mature in one year. !f the bond defaults, we assume a recovery rate. !f the mi ration probabilities are independent, we can compute the probabilities for the transition of each bond independently and multiply them to obtain the Loint probability. /y computin the value of the portfolio for each possible outcome and the probability of each outcome, we can construct the distribution for the portfolio value. #e can then find out the Q&? at a iven level of confidence. /ut in eneral, while determinin credit losses, the credit ratin chan es for different counterparties cannot be assumed to be independent. & 7aussian "opula 'odel comes in useful here. Kaussian Copula allows us to construct a Loint probability distribution of ratin chan es. The Copula correlation between the ratin s transitions for two companies is typically set e$ual to the correlation between their e$uity returns usin a factor model. & brief explanation of the rationale behind this approach follows. The historical record of ratin mi ration can be used to estimate the different Loint probabilities. .owever, this approach is often not enou h. Credit Metrics proposes an approach based on stock returns. Usin the ratin transition matrix, we know the probability of the firm mi ratin to different credit ratin s. #e use the distribution of the company;s stock returns to find out the ran es of returns that correspond to the various ratin s. #e can produce stock returns correspondin to the various ratin outcomes for each firm represented in the portfolio. !n short, the correlations between stock returns can be used to compute the probabilities of various ratin outcomes for the credits. ,or example, if we have two stocks we can work out the probability that one stock will be in

)5

)2 the & ratin cate ory and other in &&& cate ory. #hen a lar e number of credits is involved, a factor model can be used.

Correlations and :aussian Co%ula

& more detailed explanation of the Kaussian Copula is in order here. /ut before that, we need to delve into the world of correlations. !n credit risk mana ement, correlations are extremely important. Durin a crisis, default correlations across instruments tend to increase. This is essentially because the underlyin factors are the same. !n the same industry, many companies may default simultaneously. More enerally, if a market participant has exposure to two different market variables, the total exposure will be very hi h when there is a stron positive correlation. The exposure will be far less when there is a %ero correlation and would actually decrease if there is a ne ative correlation. !n credit risk mana ement, correlations have to be monitored as closely and systematically as volatility in case of market risk mana ement. The coefficient of correlation between two variables x, y can be written as' The covariance between x and y can be written as'
) xy x y n

xy

) xy x y . !n other words, the n

correlation coefficient is nothin but the covariance divided by the product of the two standard deviations. #hile the coefficient of correlation is a useful parameter, it does not tell us the full story. !t measures only the linear dependence between two variables. #e need other parameters to understand the non linear dependence. This is where copulas come in handy. #e will come to copulas a little later. 9et us et back to covariance. .ow do we compute covarianceD 9et us define the covariance of daily returns per day between two variables, x, y. !f xi, yi are the values of xi xi ) yi yi ) the two variables at the end of day i , the returns on day i are and . xi ) yi ) The covariance between x, y is
) xn yn x n yn . !f we assume the expected daily n

returns are %ero, the same assumption we made while calculatin volatility, "ovn E
) ) ) 4 4 xn yn . The variances of xn and yn are xn and yn . n n n

&s in the case of volatility, we can use an exponentially wei hted movin avera e model to et updated values of the covariance. Covn E Covn-) H 6)-: xn-) yn-). #e could also use a K&?C. model to estimate the covariance. !f we use a K&?C. model, we could write' Covn E H Xxn-)yn-) H Covn-). !t is important that variances and covariances are calculated consistently. ,or example, if variances are calculated by ivin e$ual wei ht to the last m data points, the same should

)2

41 be done for covariances. !f we use an +#M& 6+xponentially #ei hted Movin &vera e: model, the same should be used for variances and covariances. Pow we are ready to discuss copulas. 9et us say there are two variables Q ), Q4, which are not completely independent. The mar inal distribution of Q ) is its distribution assumin we know nothin about Q4. The mar inal distribution of Q4 is its distribution assumin we know nothin about Q).
Country risk management at UBS Credit risk and country risk are closely related. U/( assi ns ratin s to all countries to which it has exposure. (overei n ratin s express the probability of occurrence of a country risk event that would lead to impairment of U/(;s claims. ,or all countries rated three and below, U/( sets country risk ceilin s for all exposures to clients, counterparties or issuers of securities from the country, and to financial investments in that country. Country risk measures cover both cross-border transactions and investments, and local operations by U/( branches and subsidiaries in countries where the risk is material. +xtension of credit, transactions in traded products and positions in securities may be denied on the basis of a country ceilin , even if exposure to the name is otherwise acceptable. Counterparty defaults resultin from multiple insolvencies or eneral prevention of payments by authorities are the most si nificant effects of a country crisis. /ut U/( also considers the probable financial impact of market disruptions arisin prior to, durin and followin a country crisis. These mi ht take the form of severe falls in the country;s markets and asset prices, lon er-term devaluation of the currency, and potential immobili%ation of currency balances. The potential financial impact of severe emer in markets crises is assessed by stress testin . U/( also considers the possibility of restrictions on, cross-border transfers of funds which mi ht prevent a li$uidity surplus in one country bein used to meet a shortfall in another. Unexpected economic stress situations or soverei n defaults, mi ht induce a overnment to limit or prohibit the transfer of funds outside the country. U/( assesses the potential impact on its li$uidity position of potential transfer risk events in countries with a one-year probability of default of <8 or more as indicated by U/(;s internal soverei n ratin .

$ource' U/( &nnual ?eport, 4115

41

4) .ow do we establish the correlation structure between Q) O Q4D !f the two mar inal distributions are normal, we can assume that the Loint distribution of the two variables is also normal. /ut when the mar inal distributions are not normal, we run into a problem. (o we use the Kaussian Copula. #e map Q ) into U) and Q4 into U4 such that U) and U4 are normal variables. To elaborate, the ) percentile point of the Q) distribution is mapped to the ) percentile point of the U ) distribution and so on. (imilar mappin is done between Q4 and U4. Thus copulas enable us to define a correlation structure between Q) and Q4 indirectly. Copulas can also be used to establish the correlation structure between more than two variables. 9astly, instead of the Kaussian copula, we could also use the t Copula. &s the name su ests, the variables U), U4 are now assumed to have a bivariate t distribution.

Credit Risk Ca%ital6 Basle II frame<ork

>ne of the key obLectives of any risk measurement exercise is to understand how much capital must be set aside. Three different approaches are available to calculate the credit risk capital under /asel !! norms. #e shall cover this topic in more detail in a separate chapter. #hat follows here is a brief account. $tandardised approach !n the standardi%ed approach, the risk wei hts are determined on the basis of ratin s provided by an external credit ratin a ency. ,ixed risk wei hts are used correspondin to the de ree of risk in each asset cate ory. /asel ! had only five wei hts. /asle !! is more ranular with )= cate ories of risk wei hts ran in from 41 to )<18 dependin on the type of counterparty and ratin status. !n such cases as low rated securiti%ed assets, the wei hts can o up to =<18. 8nternal +atings )ased approach .ere, banks can use their own estimates of credit risk. The exposures are cate ori%ed into six broad classes of assets " corporate, soverei n, bank, retail, e$uity and purchased receivables. #ithin the corporate asset class, five sub classes of speciali%ed lendin have been separately identified. (imilarly in case of retail assets, there are three sub classes of exposures - exposures secured by residential properties, $ualifyin revolvin retail exposures and all other retail exposures. !?/ is divided into two cate ories " -oundation and Advanced. Under the ,oundation approach, banks estimate the probability of default and rely on supervisory estimates for other risk components. !n the advanced method, banks provide their own estimates of probability of default, loss iven default and exposure at default. To use the !?/ approach, banks must meet various criteria laid down by the re ulatory authorities.

Credit deri'ati'es
>n paper, banks mana e their credit risk throu h diversification. /ut there are limits to diversification. ,or example, banks may not like to turn down customers with whom they have a valuable relationship even if the exposure has crossed prudent limits. &ssi nment of loans to another counterparty is also not that easy. Customers may not like their loans 4)

44 bein sold off by the bank to another entity. Due to these reasons, the concentration of credit risk on the bankin books is often much hi her than desirable. Credit derivatives have emer ed to deal with such problems. 8n simple terms, a credit derivative can be defined as an instrument that allows one party to transfer an asset9s credit risk to another party without passing on the ownership of the asset. The two parties in a credit derivative transaction are the protection buyer who pays a premium and protection seller who stands ready to provide compensation in case of a credit event. The instrument or roup of instruments with respect to which the credit risk is bein traded is called referenced obligation. The reference obli ation is sometimes called reference asset or reference credit. Credit derivatives till now have been privately ne otiated, over-thecounter 6>TC: instruments. /ut now there are proposals from re ulatory authorities in the U( and +urope to establish central clearin arran ements for various >TC derivatives. Thanks to credit derivatives, banks can continue to make loans and hed e the risks involved. &t the same time, the counterparty which oes short on the credit derivative can ain access to an exposure which seems to make business sense. !ndeed, credit derivatives can be used to create almost any desired risk profile. (ay the bank is fine with the credit exposure to a specific client but is worried about a downturn in the industry. & suitable credit derivative can be structured. Credit derivatives also help in increasin the li$uidity for banks. /y limitin the bank;s downside risk, banks will be more willin to lend more to many businesses. This will ensure healthy rowth of credit, so vital to maintain economic rowth. ,rom a systemic point of view, credit derivatives represent an efficient way of separatin and tradin credit risk by isolatin it from other risks such as market risk and operational risk. Thanks to the !nternational (waps O Derivatives &ssociation, !(D&, credit default a reements have become standardi%ed. (o buyin and sellin credit protection has become easy and strai htforward. Credit derivatives also have a useful si nalin value. They provide an additional source of market based information about the company;s financial health. There is an ar ument that Credit Default (wap 6CD(: prices because they are market determined convey better information about the probability of default, than credit ratin s which only reflect the views of an a ency. Credit derivatives support market completion by providin access to credit exposure in ways that would not have been possible otherwise. ,or example, a bank may not actually lend to a company but by oin short on the CD(, it can assume an e$uivalent risk exposure. &nd even if a company;s bonds are not traded, synthetic exposures can be created. Credit derivatives have also helped in the inte ration of different se ments of financial markets. ,or example, the dividin line between bonds and loans has become considerably thinner, thanks to CD(.

44

4=

0he rise and fall of credit deri'ati'es

The ori in of >TC credit derivatives can be traced back to bond insurance which involves compensation in the event of a default. /ond insurance has been around for several decades now, but credit derivatives have become popular only in the past )< years or so. !n )22=, transactions be an to be structured which involved a periodic fee payment by the banks. !nvestors would pay compensation in case of a credit event. The first synthetic credit derivatives product was launched by N 0 Mor an in )227. The outstandin notional value of credit derivatives rew from M)51 million in )227 to more than M) trillion in 411), reachin M< trillion at the end of 411F. The credit derivatives market exploded in the build up to the sub prime crisis, reachin a notional value of M34 trillion at the peak. (ince then due to nettin and *trade compression,- the value has come down. /ut even now the fi ure is si nificant. Credit derivatives played an important role in the subprime crisis. &!K collapsed due to hu e credit default swap positions it built on its books. Pot surprisin ly re ulators and economists have expressed deep concerns about the indiscriminate use of credit derivatives. ?ather than se re ate and transfer credit risk, economists ar ue that these instruments seem to have added to the systemic risk. 9et us understand the basis for these concerns. /anks which lend to clients but offload their credit risk by purchasin credit derivatives, have little incentive to monitor their clients, even thou h they are the best e$uipped to do so in several respects. This has a ne ative impact on the way credit risk is mana ed at a system level. The protection seller in a CD( may have the motivation but is not as well e$uipped as the bank to monitor credit risk. The net effect is less monitorin oversi ht than what is desirable. !t also leads to the moral ha%ard problem as far as borrowers are concerned. #hen they know that they are not bein actively monitored, borrowers can afford to indul e in imprudent risk takin . !n the case of +nron, which went bankrupt in a spectacular way, N0 Mor an Chase, Citi roup and other banks had lent billions of dollars. /ut they had simultaneously used credit derivatives to limit their credit exposure. &ccordin to one estimates, the banks used 511 swaps to lay off M5 billion of +nron risk. &nother perverse incentive which seems to have developed is that buyers of CD( on a company;s bonds may be more keen on the company filin for bankruptcy rather than revivin it durin a crisis. The CD( compensation is likely to be received immediately whereas restructurin initiatives are lon drawn out, cumbersome and uncertain in terms of outcome. !n other words, CD( buyers actually have a stron incentive to support value destruction. This phenomenon has by no means been uncommon in the aftermath of the sub prime crisis as many companies have run into trouble. The CD( markets have also been heavily critici%ed for their opa$ueness. The markets are of the >TC type and unre ulated. (o the $uality of disclosure by the players involved is clearly not ade$uate. Moreover, a party can unwind its position by offloadin it to

4=

4F another counterparty without informin the ori inal counterparty. &s ,rank 0artnoy O David (keel mention3, *!f suppliers, bond holders or other stakeholders do not know whether the bank is hed ed, the informational content of the bank;s actions will be muddied. This uncertainty is itself an important cost of the credit default swap market.Many investors place hi hly levera ed bets on CD(. (o even a relatively small chan e in the market position can tri er a crisis. !f there is a rush by market participants to unwind a vast array of interconnected contracts, there would be a serious li$uidity crisis. (uch concerns were serious when /ear (tearns and 9ehman /rothers approached bankruptcy. That also probably explains why the U( Treasury was desperate to save &!K. Credit derivatives are relatively less li$uid instruments compared to currency or interest rate derivatives. This is because of the uni$ue nature of individual reference credits. /ecause of the lack of li$uidity, the protection sellers can face problems if they try to hed e their derivative position. !n many situations, the credit derivative may also be vulnerable to basis risk. There may be an imperfect correlation between the reference obli ation and the underlyin risk. !n case of Collateralised Debt >bli ations 6CD>s:, there is another serious problem " the mispricin of credit. (imilar assets should have similar values. !f CD>s are able to create value by repacka in assets, it means there must be some inefficiencies in the corporate debt market. /ut this mispricin should lo ically be removed by the buyin and sellin of bonds. &rbitra in opportunities rarely persist unless there is an information asymmetry or a re ulatory issue. The investors in CD> tranches are usually sophisticated people. &nd there is no re ulatory explanation that can be offered for synthetic CD>s. #hat seems to be the case is that the complex arbitrary and opa$ue ratin methodolo ies create arbitra e opportunities without actually addin any real value. !n short the *valuemay be the result of errors in ratin the assets, errors in calculatin the relationship between the assets and the tranche payouts or errors in ratin the individual CD> tranches. &s 0artnoy O (keel mention 7, *0ut another way, credit ratin a encies are providin the markets with an opportunity to arbitra e the credit ratin a encies; mistakesY The process of ratin CD>s becomes a mathematical ame that smart bankers know they can win. & person who understands the details of the model can tweak the inputs, assumptions and underlyin assets to produce a CD> that appears to add value, even thou h in reality it does not.- !n other words, there is a very stron ar ument emer in that CD>s have been used to convert existin fixed income instruments that are priced correctly into new ones that are overvalued.

0y%es of credit deri'ati'es

3 7

*The promise and perils of credit derivatives,- #orkin 0aper, University of (an Die o (chool of 9aw. *The promise and perils of credit derivatives,- #orkin 0aper, University of (an Die o (chool of 9aw.

4F

4< The term credit derivatives may have been coined in recent decades. /ut many traditional instruments have carried features of credit derivatives. ,or example, letters of credit uarantee payment in case of a default. /ut credit derivatives, as we know them today, differ si nificantly from these traditional instruments. 9et us understand some of the key features of credit derivatives. !n eneral, credit derivatives can be classified on the basis of' (nderlying credit . sin le entity or a roup of entities "onditions of exercise . default, ratin down rade, increase in credit spread. %ay off function . fixed amount, linear pay off, non linear pay off.

!n a single name "4$, the contract is between a protection buyer and a protection seller. !n a basket "4$, there is a portfolio of assets. !n a first to default "4$, compensation is payable after the first default. The structure is terminated after the first event. !n an nth to default "4$, the pay off occurs only when the nth default happens. !n a standard basket "4$, compensation is payable for each and every default. The key factor in determinin the spread for a basket CD( is the default correlation of the reference entitles in the basket. !f the default correlation between the reference entities is %ero, the probability of multiple defaults will be very low. !n other words, the value of a first-to-default CD( will be si nificantly hi her than that of say a )1 th-to-default CD(. >n the other hand, if the default correlation amon the reference entities is perfect, either all the reference entities will default or none will default. !n such a case, a first-to-default and an )1th-to-default CD( will have the same value. The conditions of exercise depend on how the credit events are defined. Credit events can be default, bankruptcy, failure to pay, restructurin , widenin of credit spread, etc. The pay off is usually linked to the amount that cannot be recovered. This is often measured by par value " price of the bond after the credit event. &lternatively the protection buyer can hand over the reference asset to the protection seller and receive a cash payment e$ual to the par value. ,inally, a credit derivative may also be structured with a binary payout. This means in case of a credit event, the payment is fixed and independent of the actual impairment.

Credit (efault S<a%s

#e have already been referrin to Credit Default (waps 6CD(: in this Chapter. Pow, it is time to understand CD( in more detail. !n many ways, the CD( is the simplest form of credit derivative. !t is also by far the most popular credit derivative. !n a CD(, one party sells protection a ainst default on an underlyin instrument to another party. Unlike insurance contracts, the two parties involved in a CD( may have nothin to do with the reference entity. !n other words, the parties may be bettin on the probability of default of an instrument issued by a third party. !t is precisely because of this element of speculation, that the CD( market hit M34 trillion in notional value at its peak. 6!n the past )5 months, however, the market has shrunk si nificantly due to offsettin of contracts.:

4<

43 The protection buyer pays a premium while the protection seller stands ready to compensate the buyer in case of a credit event. &s mentioned earlier, the compensation may be fixed or variable. Qariable compensation may be either in cash or payment of face value a ainst the receipt of the underlyin bond. Cash settlement is preferred when transfer of the ownership of the obli ation is difficult. >n the other hand, the protection seller may prefer physical settlement if this enables direct interaction with the bankrupt entity durin post default ne otiations. The protection buyer too may prefer this arran ement as the payment is transparent and not subLect to any uncertainty or dispute about the exact recovery value of the underlyin asset. CD( is certainly a form of credit insurance. /ut it does not eliminate credit risk. &ll that happens is that exposure to the underlyin credit is replaced by that to the protection seller. The effectiveness of CD( as a credit insurance mechanism implicitly assumes a low correlation between the default risk of the underlyin credit and the protection seller. 9et us briefly understand the important terms used in the context of CD(' The premium amount paid by the protection buyer, as a percenta e of the notional principal is called the "4$ spread. The premium is often expressed as basis points. The premium can also be a lumpsum amount. The reference entity is defined as the entity on which the protection is bou ht and sold. & credit event is defined as the situation that will tri er the payment of compensation by the protection seller to the protection buyer. The three most important credit events are bankruptcy, failure to pay and restructuring. !n case of a credit event, the purchaser of the CD( can sell a bond issued by the reference entity to the seller of the CD( and receive the par value. This bond is called the reference obligation. The par value of the reference obli ation is termed as the swap;s notional principal. &lternatively, cash compensation is possible. The protection seller can pay the difference between the reference obli ation;s par and market value.

& CD( can be unwound in three ways. The counterparties can exchan e the current market-to-market value. &ll the future cash flow streams are cancelled. The on oin le al risk is eliminated. The second way to unwind a CD( is to replace the current investor by a new counterparty. &ssi nment will be subLect to the protection buyer a reein to take on the counterparty risk of the protection seller. The third way to unwind a CD( is throu h an offsettin transaction. &n offsettin lon or short protection can be entered into with another counterparty. /ut such an unwindin involves si nin of further documentation and adds to le al risk. #here the position is illi$uid and assi nment is not possible, this kind of unwindin may

43

47 make sense. !ntuitively, the mark-to-market value of a CD( is e$ual to the cost of enterin into an offsettin transaction.

=ther 'ariations of C(S

&n asset default swap is essentially a sin le name CD( where the underlyin reference is an asset backed security. !n an e2uity default, swap, compensation is payable if the stock value falls below a pre specified level. & callable default swap is a CD( that can be terminated by the protection buyer at some strike spread at a future date. Thus it is nothin but a CD( with an embedded short receiver option. +ffectively, this means the protection buyer has the ri ht to *sell backto the protection seller. The protection buyer will be motivated to do so if there is sufficient spread ti htenin . This way, the protection buyer can avoid payin what looks like a hi h premium, oin by the current market scenario. !n return for this facility, the callable default swap spread tends to be hi her. & total rate of return swap 6T?>?(: is another way of transferrin credit risk. >ne party passes on the total return on a security, in exchan e for a fixed return calculated as 9!/>? plus some spread. The cash flows are exchan ed on specific payment dates. &t the end of the swap, the accumulated ain or loss in the value of the security is exchan ed. The different elements of a T?>?( are reference asset, total return payer and total return receiver. !f the underlyin asset is a portfolio of bonds owned by the total return payer, the payer transfers the credit risk of the portfolio to the total return receiver. !f the credit $uality of the portfolio deteriorates, and there are capital losses, the receiver will bear the loss. The reference asset may be a bond, index or basket of assets. Usually, it is a widely $uoted and traded bond. The total return payer is the le al owner of the reference asset. The payer pays the total income from the reference asset in return for a floatin rate of interest. The total return receiver derives the economic benefit of ownin the reference asset without actually holdin the asset on the balance sheet. The total return includes interest@dividends, ains@losses due to market movements and credit losses. There is no exchan e of the notional principal of the swap. /ut if the reference asset is amortised over the life of the swap, the notional principal is reduced accordin ly. T?>?( are sometimes collaterali%ed and marked-to-market daily. The cash flows may be exchan ed periodically or at maturity. &ny increase or decrease in the value of the asset leads to cash flows. !f the asset has increased in value, the total return payer must pass on the increase in value to the total return receiver. !f the asset has decreased in value, the total return receiver must compensate the total return payer. !n case of a default, the T?>?( terminates and the total return receiver must pay compensation.

S%ecial %ur%ose 'ehicles and C(=s

47

45 Collateralised Debt >bli ation 6CD>: is the eneral term for an asset backed security that issues securities and pays principal and interest from an underlyin pool of debt instruments. !f the underlyin pool consists entirely of bonds, it called a Collateralised /ond >bli ation 6C/>:. !f it consists only of loans, it is called Collaterali%ed 9oan >bli ation 6C9>:. CD>s are used to repacka e securities to create structured products with a completely different risk complexion, compared to the underlyin debt instruments. CD>s are divided into tranches with different de rees of certainty re ardin payments and conse$uently different credit ratin s. The tranche with the lowest credit ratin is called the e2uity tranche. The hi hest credit rated tranche is referred to as senior or super senior. !n between there are me::anine tranches. Usually, the ori inator of the CD> retains the e$uity tranche. !n a balance sheet "4;, the main motivation is to remove selected assets from the balance sheet to mana e credit risk, improve li$uidity, etc. Arbitrage "4;s focus on creatin structured products that take advanta e of the spread between assets in the pool and the promised payments to security holders. #hereas balance sheet CD>s tend to be *static,- arbitra e CD>s are mana ed actively. "ash flow arbitrage "4;s depend primarily on cash flows from the underlyin pool of assets to dischar e the obli ations towards investors. 'arket value arbitrage "4;s sell securities in the pool from time to time to meet the obli ations towards investors. The de ree of active mana ement has an impact on the le al and accountin aspects of the CD>. Many structured credit products can be created throu h securiti%ation. & special purpose vehicle 6(0Q: often substitutes the investment bank. The (0Q is a le al trust that purchases and holds the notes as collateral and simultaneously enters into a CD( as a protection seller. The (0Q issues securities to investors. !n a synthetic CD>, the money collected is invested in risk free instruments. &t the same time, a portfolio of CD( is sold to third parties. !n the absence of a credit event, the (0Q makes the coupon payment as well as the premium on CD( to investors. &fter a credit event is tri ered, the (0Q li$uidates the notes. ,irst the CD( protection buyers are taken care of. Then the remainder is distributed to the shareholders. !n a synthetic CD>, unlike cash CD>, assets are retained by the sponsorin or ani%ation. They are not transferred to the (0Q. The performance of a synthetic CD> is not linked to an underlyin revenue stream but to a reference portfolio of assets. ?eferencin a portfolio can be done throu h a CD(, total return of rate swap or credit linked note. Unless stated specifically, a synthetic CD> normally uses CD( to transfer risk. +ssentially, in a synthetic CD>, CD( and overnment bonds are combined to substitute corporate loans as the assets in the (0Q. The premium from the CD( and the interest earned on risk free securities are paid to investors in a way that reflects the risk they are bearin . #hen the CD( is tri ered, the asset value is reduced. The pay off for the

45

42 lower tranches depends on the amorti%in rate of the assets, which is determined by the number of CD(s tri ered. The market has standard definitions of CD> tranches. (o individual tranche tradin is also possible. & (in le Tranche CD>, 6(TCD>: is a contract between two parties on a particular tranche of a synthetic CD> on a standalone basis. !n a sin le tranche, one side sells protection a ainst losses on a tranche and the other side a rees to buy the protection. !f the correlation between the CD> assets is low, the e$uity tranche will be very risky. /ut the senior tranches will be relatively safe. >n the other hand when the correlation is perfect, all the tranches will be e$ually risky. !t is clear that durin the sub prime crisis, correlations turned out to be hi her than expected. /anks such as U/( ot into bi trouble with their super senior tranches. #e need to differentiate between corporate CD( and &/( 6&sset /acked (ecurities: CD(. !n the corporate market, the focus is on the corporate entity. 9ess emphasis is placed on the credit;s individual obli ations. !n the &/( market, the focus is on a specific instrument typically a particular tranche from a particular securiti%ation of a particular ori inator. !n case of corporate CD(, the usual practice is for all obli ations of a seniority to be reference obli ations. !n the corporate CD( market, it does not much matter which senior unsecured obli ation is tendered for physical settlement or marked to market for cash settlement. !n the case of &/( CD>, each tranche has a distinct credit $uality and a distinct credit ratin . &/( CD( focus on the specific tranche. The credit problem in case of a corporate CD( is clearly defined. Credit events are easily discernable. >n the other hand, credit problems in &/( securiti%ation are not that clearly defined. The flexibility of an &/( tranche;s cash flows means that the existence or extent of a credit problem is ambi uous. 0roblems may resolve themselves. They will usually not rise to the same level of distress as a defined credit event in a corporate CD(. Many &/( tranches stipulate deferment of interest payments if collateral cash flow is insufficient due to delin$uencies and defaults. 9ater, if cash flow recovers, deferred interest can be made up.

42

=1 Exhibit ! Im%act of &inancial Sector Stabili>ation Measures on Credit (efault S<a% -C(S/ S%reads

+ef' !M, Klobal ,inancial (tability ?eport, >ctober 4112, www.imf.or

Credit s%read &or<ard

The protection buyer and protection seller a ree to a credit spread. The buyer receives the difference between the credit spread at maturity and an a reed " upon spread, if positive. >n the other hand, if the difference is ne ative, a payment is made. !f i is the prevailin spread and r is the a reed upon spread and the modified duration is 4, then the compensation payable to the buyer is iven by' Compensation E 6i - r: 6D: 6Potional amount:.

Credit s%read o%tions

Credit-spread options are options on asset swaps. They are used to hed e a ainst the risk of chan es in credit spreads. & reference asset is selected and a strike spread and maturity are set. The pay off depends on whether the actual spot spread on the exercise date is above or below the spread on the reference security. The credit spread can be relative to a risk free instrument or any other bond. Credit spread options may be of the +uropean or &merican type.

=1

=) The buyer of a call option has the ri ht to buy the spread at a pre specified strike price. (uch an option has value if the spread at exercise is reater than the specified strike spread. The buyer of a credit spread put option has the ri ht to sell the spread at a pre specified strike price on the exercise date. The option has value if the spread at exercise is less than the strike spread.

Credit S<a%tions
& credit swaption involves payment streams that are contin ent on the occurrence of a credit event. & swaption is nothin but an option on a swap. The holder of a swaption can enter into a swap with a pre specified fixed payment stream over a specified period of time. & credit swaption can be an option to buy or sell credit protection at a pre specified CD( strike spread. The underlyin is the forward CD( spread from the option expiry date to the maturity date of the CD(. & swaption can be +uropean, &merican or /ermudan. !n a payer default swaption, there is a ri ht to buy the protection. The option holder benefits if the spread widens sufficiently enou h by the maturity date. The receiver default swaption confers the ri ht to sell protection. The option holder benefits if the spread ti htens sufficiently enou h by the maturity date. & credit default swaption can also be structured with a provision for a knockout. !f there is a credit event between the trade date and the expiry date, the knock out provision cancels the default swaption with immediate effect. The payer default swaption buyer will have the ri ht to buy the protection at the strike spread. !n case of a receiver default swaption, the reference spread would widen and the option would not be exercised after a credit event. (o a knock out provision is not needed. Credit default swaptions may be structured such that the underlyin asset is a credit index. This may be preferred if the investor wants to take a macro view as opposed to a view on a specific credit. 0ortfolio volatility also tends to be lower.

Credit linked note

& credit linked note 6C9P: is a funded credit derivative. ,eatures of the derivative are embedded in a eneric cash instrument. Typically, a C9P combines a credit derivative with a re ular bond. The credit risk is transferred throu h the issue of bonds either directly by the protection buyer or by a (pecial 0urpose Qehicle 6(0Q:.The investor is the credit protection seller while the issuer of the note is the protection buyer. The investor@protection seller pays up front the par value of the bond and receives interest payments at 9!/>? plus a spread. !n case of a credit event, the investor will receive the recovery value of the underlyin asset in the CD( and lose claim over the principal. >r to put it differently, the investor will receive the principal less the amount that cannot be recovered. & true credit derivative C9P has a third party as reference name. The settlement process is similar to that of CD(. The protection buyer, in case of a cash settlement, will pay the recovery value to the protection seller. !n case of physical settlement, the note is terminated. The reference security is handed over to the protection seller.

=)

=4

(ome C9Ps may be issued by a party which is also the reference name. The occurrence of a credit event implies immediate termination of the bond. Po settlement process is needed because the protection seller is already holdin the bond. & standard C9P is issued with reference to a specific bond. & C9P that is referenced to more than one credit is called basket credit linked note. & variant of the basket C9P is the first-to-default "36, in which the investor is sellin protection on the first credit-todefault. The return on the C9P is a multiple of the avera e spread of the basket. !n a physical settlement, the defaulted asset is delivered to the bond holder. !n cash settlement, the C9P issuer pays redemption proceeds to the bond holder. This is nothin but the difference between the principal and recovery value. (ynthetic C9P can be issued by a (0Q that holds collateral securities financed by the issue. The (0Q uses the issue proceeds to purchase the collateral and then sells credit protection to a counterparty. The (0Q also provides interest on the collateral a ainst the (0Q;s future performance under the CD(. The (0Q may also enter into an interest rate swap to modify cash flows suitably. ,or example, the cash flows on the collateral may be fixed rate but the C9P cash flows may be re$uired in floatin rate form. The C9P coupon is the sum of the returns on the collateral and the CD( premium. !nvestors in the C9P receive their coupon and principal at the time of redemption in the absence of any credit event. !f a credit event happens durin the life of the C9P, the collateral is sold to form the par payment made by the (0Q to the CD( counterparty. The C9P is redeemed by the issuer at %ero percent. &ccrued interest payments from the collateral@CD( premium form an accrued C9P coupon which the investor receives. The CD( counterparty is only eli ible for )118 of the notional amount. +xcess value of the collateral belon s to the investors. !f the collateral has lower than market value, the CD( counterparty receives the compensation. The counterparty reduces the amount of defaultable obli ations it delivers. #hen the market value of the collateral falls sharply, the investor loses the entire notional value of the C9P. The CD( counterparty will also suffer a loss. The collateral provides a base return to the investors and acts as a collateral for the CD( counterparty. (o the collateral must be acceptable to both the parties. The collateral should be chosen such that the probability of thin s oin wron with the reference entity and collateral, simultaneously is minimi%ed. !n eneral, the C9P investors are exposed to three kinds of risk' Credit risk of the reference entity Credit risk associated with the securities makin up the collateral Counterparty risk associated with the protection buyer.

=4

== !f the collateral is hi hly rated and the CD( counterparty is hi hly rated, the focus shifts to the credit risk of the reference entity. #hen the (0Q uses interest rate swaps to modify the cash flows, there is an additional source of risk. +ffectively, C9Ps ive investors an opportunity to exploit anomalies in pricin between the cash and credit protection markets. C9Ps enable investors to customi%e their exposure with respect to currencies, maturities and coupon structures. C9Ps can be traded in the same way as bonds. /ut C9Ps lack li$uidity, when compared to bonds. Moreover, there are fixed costs associated with the creation of the (0Q and the various aspects of the C9P. (o C9Ps may make more sense for medium term rather than short term investors. & ood example of C9P use is Citi roup which had considerable exposure to +nron in 4111. Thou h +nron at that time was flyin hi h, Citi roup decided to hed e the exposure usin securities which resembled credit linked notes. Citi created a trust which issued the securities in the form of five year notes with interest payments. The proceeds were invested in hi h $uality debt. !f +nron did not o bankrupt, investors would receive the principal after < years. !n the event of bankruptcy, Citi could swap the loan it had made to +nron, for the securities in the trust.

Conclusion
Credit risk mana ement is more complex compared to market risk mana ement with re ard to data availability and modelin . Credit risk is also firm specific unlike market risk. !s this chapter, we have tried to understand the basic principles of measurin credit risk. #e have also seen how credit risk can be mana ed usin credit derivatives. &s financial instruments become more and more complex and speciali%ed, the distinction between market and credit risk is becomin increasin ly blurred. #e shall examine this theme in more detail in a later chapter.

==

=F References'
+.! &ltman, *,inancial ?atios, Discriminant &nalysis and the 0rediction of Corporate /ankruptcy,- !ournal of -inance, (eptember )235, pp. <52-312 ?obert C Merton, *>n the 0ricin of Corporate Debt' The ?isk (tructure of !nterest ?ates,Nournal of ,inance, 42, )27F, pp. FF2-F71. +dward. !. &ltman, *Credit risk measurement and mana ement' The ironic challen e in the next decade,- Pew Zork University (tern (chool of /usiness, #orkin 0aper, ,ebruary )225, ,!P-25-11=. ?an araLan A (undaram, *The Merton@AMQ &pproach to 0ricin Credit ?isk,- #orkin 0aper, (tern (chool of /usiness, Nanuary 4, 411). Nohn C .ull, *>ptions, ,utures and >ther Derivatives,- 0rentice .all, 4113 Nohn C .ull, *?isk Mana ement and ,inancial !nstitutions,- 0earson +ducation, 4117. 0hilippe Norion, *,inancial ?isk Mana er .andbook,- Nohn #iley O (ons, 4117. Nohn / Caouette, +dward ! &ltman, 0aul Parayanan and ?obert # N Pimmo, *Mana in Credit ?isk " The reat challen e for lobal financial markets,- Nohn #iley O (ons, 4115. U/( &nnual ?eports, 4117 O 4115. ,rank 0artnoy, David & (keel, *The promise and perils of credit derivatives,- #orkin 0aper, University of (an Die o (chool of 9aw.

=F