IIM, INDORE

Exotic Credit derivatives

and Lehman brothers: A
case analysis
By
V.V.P.Narasimham

2009

[Type text] Page 1

EPGP 07-09
 Exotic Credit derivatives and Lehman brothers: A case analysis

Table of Contents

1. Introduction………………………………………………………………………5
1.0 Review of Sub prime crisis
1.1 About Mortgage backing business of Lehman brothers
1.2 Factors influenced the Bankruptcy of Lehman Brothers
1.3 Objectives of the study
2. Brief review of Credit derivative swaps…………………………………………..9
2.0 History and future application of CDS
2.1 Application of Credit derivatives
2.2 Types of Credit derivatives
2.3 Market over view of credit derivatives
2.3.1 Single type credit default swap
2.3.2 Credit option
2.3.3 Credit linked notes
2.3.4 Synthetic CDO
2.3.5 Basket default swaps
2.3.6 CDO Squared
2.3.7 Hybrid products
3. Pricing and valuations………………………………………………………………16
3.0 General considerations for Pricing and valuations of credit options
3.1 Credit default swap
3.1.1 Assumptions for pricing the product
3.1.2 Analysis on the effect of Single type CDS on Lehman brothers
3.2 Pricing of Synthetic debt obligation
3.2.1 Analysis of the impact of Synthetic CDO on Lehman brothers
3.3 Valuation of credit options
3.4 Valuation of Basket default swap
3.5 Valuation of Hybrids
4. Conclusions & Recommendations………………………………………………….27
5. References……………………………………………………………………………28

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 Exotic Credit derivatives and Lehman brothers: A case analysis

List of Figures

Figure 1 View of losses suffered by financial institutions and investment Bankers due to sub
prime crisis

Figure 2 Comparison of Effect of sub price effect with other crisis

Figure 3 Value of commercial properties in 2008

Figure 4 Estimation of revenues by various derivative instruments for investment Bankers

under various scenario's by 2010

Figure 5 Break up of various instruments in credit derivatives market

Figure 6 Frame work of Single type CDS

Figure 7 Frame work of Credit options

Figure 8 Frame work of Credit link Notes

Figure 9 Frame work for Synthetic CDO

Figure 10 Mechanics of Synthetic CDO

Figure 11 Frame work for Basket default Swaps

Figure 12 Probabilistic Valuation model for of Single type CDS

Figure 13 Comparison of PV for Premier leg% & Protection leg

Figure 14 Variation of CBE for change in Spread rate

Figure 15 values of Equity tranche for variation in Rho

Figure 16 CBE values of Equity tranche for variation in Rho

Figure 17 CBE values of Senior tranche for variation in Rho

Figure 18 CBE values of Mezzanine tranche for variation in Rho

Figure 19 CBE values of super senior tranche for variation in Rho

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 Exotic Credit derivatives and Lehman brothers: A case analysis

List of Tables

Table 1 Calculation of PV for Premier leg and Protection leg

Table 2 Calculation of payoff for different probabilities

Table 3 Calculation of PV for default at various times

Table 4 Calculation of CBE for various tranche for different values of Rho

Table 5 Price of pre-defined for variation in spread rate

Table 6 Valuation of Receiver default swap

Table 7 Products of default swaption

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 Exotic Credit derivatives and Lehman brothers: A case analysis

1. Introduction
1.0 Review of Sub price crisis:-Sub price crisis of 2007 has shown devastating effect on
the world financial markets. Many financial institutions have suffered heavily due to this
crisis. Some companies have heavy slash in their revenues while some companies either
closed or forced to merge in other companies. Figures 1 & 2 shows pictorial view of sub price
crisis on the overall economy and its intensity on the world wide economies.

Figure 1View of losses suffered by financial institutions and investment Bankers due
to sub prime crisis

Figure 2 Comparison of Effect of sub price effect with other crisis

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 Exotic Credit derivatives and Lehman brothers: A case analysis

One of the notable among them was the Bankruptcy of Lehman Brothers. The investment
banker has filed bankruptcy statement under U.S trade laws on Sept 15, 2008 the day which
World wide markets want to forget. Lehman announced will file for Chapter 11 bankruptcy
protection, making it the biggest victim so far of the credit crunch and sub-prime crisis. The
collapse of Lehman – one of the biggest financial shocks in years - puts tens of thousands of
jobs around the world at risk and in the same week another financial firm Merrill Lynch
announced that it was also facing credit crunch and filed for Bankruptcy and subsequently it
was taken over by Bank of America for $50bn. Further for the first time recession has
occurred globally and expert are .this crisis has effected heavily Merrill Lynch and Lehman
both expanded aggressively into property-related investments, including so called sub-prime
mortgages - loans to people on low incomes or with poor credit histories. The bank has lost
$14bn in the past 18 months after being forced to take huge write-downs on the value of
those investments. These two investment bankers together held or backed $5.3 trillion in
mortgages. What is more, with the mortgage markets facing a credit squeeze over the last
year, they were providing 70 to 80 per cent of new mortgage loans. To undertake these
activities, these firms were indebted to a range of creditors; credit from many of these
creditors would freeze up if these GSEs defaulted on their commitments. Any effort on the
part of these creditors to sell their debt would result in a decline in value that would threaten
the financial viability of many of them. Thus, there were two important reasons, for this
situation.
I. Mortgage credit has dried up, resulting in a collapse of the already declining prices
in the housing market.
II. Fallout could be dire for the viability of other financial firms and the stability of
financial markets.
1.1 About Mortgage backing business of Lehman brothers:-At the time of filling
Bankruptcy Lehman Brothers it owes more than $600 billion to creditors worldwide. With
much of that money being invested in mortgage-backed securities, the collapse in the value of
those securities must have increased demands for additional collateral, which Lehman was
hard-pressed to find. Lehman was a key player in the mortgage securities business and made
its own investments in subprime mortgage securities to boost the return. By borrowing
heavily short-term funds at rock-bottom rates (given that Fed had kept rates low for a long
time) and then investing them in subprime mortgages, they were also able to boost their
quarterly profits. All this was driven by the need to pump up earnings to earn their
management’s compensation payout, even as the firm was taking on enormous debt and
having to leverage close to 40 times its capital.
1.2 Factors influenced the Bankruptcy of Lehman Brothers:-One of the notable
suffers along with Lehman brothers is the AIG insurance which was a profitable well-run
insurance company which found the "easy money" in mortgage business and decided to be
the insurer by offering a product called "credit default swap," basically an insurance to the
buyers of mortgage security that if they don’t get their money back for some reason AIG will
pay the holder of security. Basically AIG was insuring all the subprime mortgages and
earning a premium for doing so. By betting that U.S. housing prices will continue to raise
"forever" it assumed estimated a linear growth in mortgages prices. However when the US
housing prices crashed the subprime mortgage business collapsed as the home owners
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 Exotic Credit derivatives and Lehman brothers: A case analysis

defaulted massively on their mortgages which created a ripple effect in making these
mortgage securities worthless. A subprime homeowner had no incentive to pay off a
mortgage, which was worth more than the house and decided to walk away as they had taken
a "zero down" mortgage and no equity in the house. The worth of these securities was resting
on the assumption that home prices will not lose value. However, when they did, the entire
subprime market unravelled. Firms like Lehman, Fannie and Freddie, who had enormous
investments in sub prime securities relative to their capital base, had to book losses and there
was no one ready to buy these securities. The entire mortgage securities market seized, which
spilled over to the broader credit market since no one knows who has how much exposure
and what the true value of these securities is. So when one firm starts selling these securities
at distress prices it triggers a wave of write-downs in other firms as the value of these
securities has to be adjusted to reflect market value "using the mark-to-market rule." This
created further selling pressure and soon there was no buyer for these securities. If the cost of
funds is minimal and there is plenty of money available, the "free" capital will chase any
investment idea that has half a chance of success. This easy money found the perfect partner
in the U.S. mortgage business. Traditionally banks lend money for mortgages to their
customers after knowing who they are and assessing their credit worthiness. This is to ensure
that the banks get their money back. Even though the mortgages were guaranteed by Fannie
and Freddie, their criteria was fairly stringent and it meant mortgages were only given to
folks who had a steady job, a good credit score and a reasonable ability to repay the loan.
Then the role of the investment banks like Lehman, which basically found a new business in
packaging the mortgage loans and selling it to investors around the world who wanted a
higher yield. The theory was that since housing prices "only go up" these mortgage backed
securities will always hold their value and if one can earn a better yield particularly since the
yield available in treasury was next to nothing this is a very good deal. The credit rating
agencies blessed these securities with high quality ratings and the merry-go-around started.
However due to raising inflation many customers have defaulted on one upper side crushing
of the mortgage properties on the downer side and which ultimately leads to the bankruptcy
of big investment giants like Lehman brothers, AIG insurance etc.Figure 3 shows the
variation of commercial properties in the year 2008.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

Figure 3 Value of commercial properties in 2008

The present document reviews the influence of exotic credit derivatives in Bankruptcy of
Lehman brothers and its role in future risk management policies.
1.3 Objectives of the study:-Main objectives of the document are to study the impact of
exotic credit derivatives in the Bankruptcy of Lehman brothers. For this study the
methodology we adopted is as follows:-
a. Frame work and design of the exotic credit derivatives
b. Pricing and valuation
c. Analysis of the instruments based on valuations and derivation of possible reasons for
correlating to the Bankruptcy of Lehman Brothers.
d. Recommendations.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

2.0 Brief review of Credit derivative swaps

2.0 History and future application of CDS: - CDS is a credit derivative contract
between two counterparties. The credit derivatives market is the most exciting and
devastating area in the derivatives markets since 1990.It has changed the landscape of the
financial markets positively and negatively. Though critics are sceptical about the role of
credit derivatives after the debacle of Lehman brothers in sept, 08 still credit markets are
playing a great role in the financial markets. As per the estimates of the ISDA notational
principal amount for outstanding credit contracts is $182 trillion by dec, 2008. As per the
recent estimate of the BCG Revenues from credit instruments will occupy a major share in
the revenues of the Investment bankers by 2010.Figure 4 shows the estimation of revenues
from various derivative instruments for investment bankers by 2010 under various scenarios.

Figure 4 Estimation of revenues by various derivative instruments for investment

Bankers under various scenario's by 2010
This growth in the credit derivatives market has been driven by an increasing realisation of
the advantages credit derivatives possess over the cash alternative, plus the many new
possibilities they present to both credit investors and hedgers. Those investors seeking
diversification, yield pickup or new ways to take an exposure to credit are increasingly
turning towards the credit derivatives market. The primary purpose of credit derivatives is to
enable the efficient transfer and repackaging of credit risk. In their simplest form, credit
derivatives provide a more efficient way to replicate in a derivative format the credit risks
that would otherwise exist in a standard cash instrument.
2.1 Application of Credit derivatives: - A credit derivative is a derivative whose value
derives from the credit risk on an underlying bond, loan or other financial asset. In this way,
the credit risk is on an entity other than the counterparties to the transaction itself. This entity
is known as the reference entity and may be a corporate, a sovereign or any other form of
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 Exotic Credit derivatives and Lehman brothers: A case analysis

legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer
and seller under which the seller sells protection against the credit risk of the reference entity.
Main purposes of are as follows:-

Bankruptcy (the risk that the reference entity will become bankrupt) failure to
pay (the risk that the reference entity will default on one of its obligations such as
a bond or loan)

Obligation default (the risk that the reference entity will default on any of its
obligations)

Obligation acceleration (the risk that an obligation of the reference entity will be
accelerated e.g. a bond will be declared immediately due and payable following a
default)

repudiation/moratorium (the risk that the reference entity or a government will
declare a moratorium over the reference entity's obligations)

Restructuring (the risk that obligations of the reference entity will be
restructured).
2.2 Types of Credit derivatives:-Based on the form of credit derivatives can be divided
into two types.
I. Funded format-The most commonly used is known as swap format, and this is the
standard for CDS. This format is also termed ‘unfunded’ format because the investor
makes no upfront payment. Subsequent payments are simply payments of spread and
there is no principal payment at maturity. Losses require payments to be made by the
protection seller to the protection buyer, and this has counterparty risk implications.
II. Unfunded format-The other format is to trade the risk in the form of a credit linked
note. This format is known as ‘funded’ because the investor has to fund an initial
payment, typically par. This par is used by the protection buyer to purchase high
quality collateral. In return the protection seller receives a coupon, which may be
floating rate, i.e, Libor plus a spread, or may be fixed at a rate above the same
maturity swap rate. At maturity, if no default has occurred the collateral matures and
the investor is returned par. Any default before maturity results in the collateral being
sold, the protection buyer covering his loss and the investor receiving par minus the
loss. The protection buyer is exposed to the default risk of the collateral rather than
the counterparty.
2.3 Market over view of credit derivatives:-Various types of exist in the market
depending on the customers needs and the risk perception. Financial engineering also plays a
great role in designing the product. Figure 5 shows the breakdown of the different
instruments in credit derivatives market.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

$0.85

Credit default swaps

$11.10

Credit linked notes

$1.30
$1.75 Options and hydrids

$35.00 Portfolio correclation

products
Total return Swaps

Figure 5 Break up of various instruments in credit derivatives market

swap - A Single type credit swap is a credit default

2.3.1 Single type credit default swap: defa swap; in
its simplest form is a bilateral contract between a protection buyer and a protection seller.
This type of instrument is used for transferring the credit risk of a reference entity (corporate
or sovereign) from one party to another. In a standard CDS contract one party purchases
Credit protection from the other party, to cover the loss of the face value of an asset following
a credit event. This strategy is one of the ways to sell the credit. This protection lasts until
some specified maturity date. For this protection, the protection buyer makes quarterly
payments, to the protection seller and until a credit event or maturity, whichever occurs first.
f
This is known as the premium leg.Supose the credit event does not occurs before the maturity
date protection seller will pay the amount to the buyer and this is known as protection leg of
the CDS. Upon the completion of the maturity period asset will will be transferred in the form of
physical delivery or the cash delivery. Figure 6 shows the frame work of Single type CDS.

Figure 6 Frame work of Single type CDS

Credit options are the one of the most vibrant products sold by Lehman
2.3.2 Credit option:-Credit
brothers. This product is very popular due to the decreased spread levels, volatility and the
perceived ness of asset & Hedge fund managers for in terms of leverage and asymmetric

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 Exotic Credit derivatives and Lehman brothers: A case analysis

payoff.Furhter this product gained popularity due to its option of liquidity and high yield. The
most popular products of Credit options are the repack trade option. Lehman brothers
purchases debentures from the FI/Company at the par rate and issues coupons to the investors
at more than the par rate from the
the trust established by it. This trust is normally will be over
collateralised to compensate the higher par rate issued by it and the excess capital of the trust
will be utilised to issue A-22 tranche with the option of principal only. Both A-1&2
A tranche
comprise
prise of embedded call options. Further a separate call will be sold to the retail investors
in the form of long term warrant. These investors will have the right not obligation to
purchase the bonds issued by Lehman trust initially and thereafter preset callc strike schedule.
Bonds issued by the trust provide various options to the investors like naked call option,
Covered call option; spread call option etc.Figure
etc. 7 shows the frame work for credit options.

Figure 7 Frame work of Credit options

Strategies for selling the bonds:-
bonds:
I. Put call stripping- These bonds grant the holder the right, but not the obligation to sell
the bond back to the issuer at a predetermined price (usually par) at one or more
future dates.
II. Price based options- at exercise, the option holder pays a fixed amount (strike price)
and receives the underlying bond – the payoff is proportional to the difference
between the price of the bond and the strike price.
III. Spread based options:--at exercise, the option
tion holder pays an amount equal to the value
of the underlying bond calculated using the strike spread and receives the underlying
bond – the payoff is proportional to difference between the underlying spread and the
strike spread.
IV. Covered call strategy:-an
strategy: an investor who owns the underlying bond sells an out-of-
out
money call on the same face value, receiving an upfront premium. If the bond price

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 Exotic Credit derivatives and Lehman brothers: A case analysis

on the expiry date is greater than the strike, the investor delivers the bonds and
receives the strike price. The option
op premium offsets the investor’s loss of upside on
the price. If the price is less than the strike the investor keeps the bonds and the
premium.
V. an investor writes an out-of-the-money
Naked call strategy:-an out money put on a bond which he
does not own but would likelike to buy at a lower price. If the bond price on the expiry
date is lower than the strike price, it is delivered to the investor. The option premium
compensates him for not being able to buy the bond more cheaply in the market. If the
bond price is above the
he option strike price, the investor earns the premium.
VI. Default swaption: -These
These were protection call and protection put options.
2.3.3 Credit linked notes:-A A credit linked note is a note whose cash flow depends upon an
event, which may be a default, change in credit spread, or rating change. The definition of the
relevant credit events must be negotiated by the parties to the note. A CLN in effect combines
a credit-default
default swap with a regular note (with coupon, maturity, redemption). Given its note
like
ke features, a CLN is an on-balance-sheet
on sheet asset, in contrast to a CDS.Typically, an
investment fund manager will purchase such a note to hedge against possible down grades, or
loan defaults. Numerous different types of credit linked notes (CLN’s)
(CLN s) have been structured
and placed in the past few years. Here we are going to provide an overview rather than a
detailed account of these instruments. The most basic CLN consists of a bond, issued by a
well-rated
rated borrower, packaged with a credit default swap on a less less creditworthy risk. Figure 8
shows the frame work for credit link Notes.

Figure 8 Frame work of Credit link Notes

2.3.4 Synthetic CDO:- Synthetic CDO is form of credit derivative offering exposure to a
large number of companies in a single instrument. This exposure is sold in slices of varying
risk or subordination - each slice is known as a tranche .In these instruments underlying
credit exposures are taken on using a credit default swap rather than by having a vehicle buy
physical assets. Synthetic CDO’s
CDO can either be single tranche CDO’ss or fully distributed
CDO’s. Synthetic CDO’ss are also commonly divided into balance sheet and arbitrage
arbitra CDO’s.
They generate income selling insurance against bond defaults, typically on a pool of 100 or
more companies. One way they do so is by entering into contracts known as "credit default
swaps". Investors receive regular payments from credit-default-swap
credit wap buyers, usually which

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 Exotic Credit derivatives and Lehman brothers: A case analysis

are banks or hedge funds. Figure 9 shows the frame workk for Synthetic CDO and Figure 10
shows the mechanics of Synthetic CDO.

Figure 9 Frame work for Synthetic CDO

Figure 10 Mechanics of Synthetic CDO

swaps: A basket default swap is similar to a CDS, the difference
2.3.5 Basket default swaps:-A
being that the trigger is the nth credit event in a specified basket of reference entities. Typical
baskets contain five to 10 reference entities. In the case of first-to-default
default (FTD) basket, n=1,
and it is the first credit in a basket of reference credits whose default triggers a payment
paymen to the
protection buyer. As with a CDS, the contingent payment typically involves physical delivery

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 Exotic Credit derivatives and Lehman brothers: A case analysis

of the defaulted asset in return for a payment of the par amount in cash. In return for
assuming the nth-to-default
default risk, the protection seller receives a spread paid on the notional of
the position as a series of regular cash flows until maturity or the nth credit event, whichever
is sooner. The advantage of an FTD basket is that it enables an investor to earn a higher yield
than any of the credits in the basket. This is because the seller of FTD protection is leveraging
their credit risk. Figure 11 shows the frame work of Basket default swaps. Figure 11 shows
the frame work of Basket default swaps.

Figure 11 Frame work for Basket default Swaps

2.3.6 CDO Squared:- A special purpose vehicle (SPV) with securitization payments in the
form of tranches. A collateralized debt obligation squared (CDO-squared)
(CDO squared) is backed by a pool
of collateralized debt obligation (CDO) tranches.
tranches. This is identical to a CDO except for the
assets securing the obligation. CDO-squared
CDO arrangements are backed by CDO
tranches. CDO-squared
squared allows the banks to resell the credit risk that they have taken in
CDO’s.Typically
Typically this is a mezzanine ‘super’ tranche CDO in which the collateral is made up
of a mixture of asset-backed
backed securities and several ‘sub’ tranches of synthetic CDOs.Principal
losses are incurred if the sum of the principal losses on the underlying portfolio of synthetic
tranches exceeds the
he attachment point of the super-tranche.
super
2.3.7 Hybrid products:- Hybrid credit derivatives are those which combine credit risk with
other market risks such as interest rate or currency risk. Typically, these are credit event
contingent instruments linked to the value of a derivatives payout, such as an interest rate
swap or an FX option.

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3 Pricing and valuations

3.0 General considerations for Pricing and valuations of credit options: - Generally
pricing of credit options depends on the following factors.
a. Default probability rate
b. Recovery rate
c. Spread value
d. Asset correlations
e. Protection on the premium and protection legs.
f. Asset Quality
Based on these factors pricing and valuations can be modelled for various credit instruments.
Considering the time and availability of the resources both pricing and valuations was done
for three instruments (Single type CDR, Synthetic CDO & Credit options) only and for the
others only pricing exercise was done.
3.1 Pricing of Credit default swap:-Pricing of single type CDR’s can be done in structural
form or reduced form. In the structural approach, the default is characterised as the
consequence of some event such as a company’s asset value being insufficient to cover a
repayment of debt. This approach is based on the assumption that bonds should be traded on
the internal structure of the company. However this approach lacks flexibility. The other
approach uses in valuation of the CDS is the probabilistic approach. This approach based on
the occurrence of credit event. Pricing of single CRS depends on several factors like hazard
rate, default rate, swap spread and the Quality of asset. Pricing of CDS depends on the break
even spread which depends on the values of premier leg and protection leg. Figure 12 shows
the probabilistic valuation model for Single type CDS.
Premium PV = Protection PV

Where

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 Exotic Credit derivatives and Lehman brothers: A case analysis

Figure 12 Probabilistic Valuation model for of Single type CDS

product For pricing the product it is assumed that the
3.1.1 Assumptions for pricing the product:-For
asset will be recovered in case of default. However it suffered heavily in this stream due to
poor recovery rates at the later stages. Further while deciding the price it is assumed that
interest rate curve as well as the recovery rate of the asset is flat. However conditions due to
subprime crisis in this considerably reduced the recovery rates of the asset (Prices of assets
reduced) and this made huge losses for the Lehman brothers.Furhter default rates were wer
assumed from the historical data which is not much related to the present crisis and this also
played a great role in the losses of Lehman brothers. Tables 1-33 shows the valuation done for
Single type CDS and figure 13 shows the comparison of premier leg and protection leg
values for different rates of asset correlations.
correlations

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 Exotic Credit derivatives and Lehman brothers: A case analysis

Table 1 Calculation of PV for Premier leg and Protection leg

Recovery Hazard Interest PV of Protection PV of Premium

Time rate rate rate Spread leg leg
0.5 0.4 0.02 0.965605 0.012 0.009811 0.009811
1.5 0.8 0.02 0.900325 0.004 0.001643 0.001643
2.5 0.8 0.02 0.839457 0.004 -0.00047 -0.00047
3.5 0.8 0.02 0.782705 0.004 -0.00315 -0.00315
4.5 0.8 0.02 0.729789 0.004 -0.00647 -0.00647
0.001359 0.001359

Table 2 Calculation of payoff for different probabilities

Exp. Pay from

Calculation of default Exp. Pay from buyer Exp. Pay from Seller buyer in case of
probabilities in case of no default in case of default default
Haz Def. Sur. Exp. Dis. PV of Rec. Exp. PV of Exp. PV Of
Time Rat. Prob Prob Pay. Fact Exp.Pmt. Rate Pay. Exp.Pay Pay Exp.Pmt
0 1.00 1.18 0.97 1.14 0.40 1.20 1.16 0.01 0.01
0.5 0.02 0.02 0.98 1.15 0.90 1.04 0.40 1.18 1.06 0.01 0.01
1.5 0.02 0.02 0.96 1.13 0.84 0.95 0.40 1.15 0.97 0.01 0.01
2.5 0.02 0.02 0.94 1.11 0.78 0.87 0.40 1.13 0.88 0.01 0.01
3.5 0.02 0.02 0.92 1.08 0.73 0.79 0.40 1.11 0.81 0.01 0.01
4.5 0.02 0.02 0.90
PV 4.78 PV 4.88 PV 0.05

Table 3 Calculation of PV for default at various times

Case- Case-
Case-I II Case-I II Case-I Case-II Case-I Case-II
Total PV to Default Total PV to Default
Time Recovery rate Spread Protection Buyer: Protection seller
0.5 0.7 0.7 0.006 0.006
1.5 0.6 0.008
2.5 0.4 0.012
4.924 6.776 2.4388 2.4573
3.5 0.1 0.018
Asset Asset
4.5 defaulted defaulted

3.1.2 Analysis on the effect of Single type CDS on Lehman brothers:-

a. Decrease in Quality of assets with time
b. Decreased recovery rates and subsequent default of lender.
c. Problems in calibrating in recovery rates and default rates.
d. Prevailing low interest rates gives less chances for increasing spread.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

8.00
More payments has to paid by the premier seller
due to the poor recovery rate of asset
7.00

6.00
PV of the asset

5.00

4.00
PV of Protection leg
3.00
PV of Premium leg
2.00

1.00

0.00
0 0.2 0.4 0.6 0.8 1
Recovery rate

Figure 13 Comparison of PV for Premier leg% & Protection leg

3.2 Pricing of Synthetic debt obligation:-The performance of a synthetic CDO is linked to
the incidence of default in a portfolio of CDS. The CDO redistributes this risk by allowing
different tranches to take these default losses in a specific order
This risk is redistributed into three tranches as given in previous chapters. Out of these three
tranches, the equity tranche has the greatest risk and is paid the widest spread. It is typically
unrated. Next is the mezzanine tranche which is lower risk and so is paid a lower spread.
Finally the senior tranche is having less risk perception & is normally protected by
subordination debt clause. The advantage of CDO’s is that by changing the details of the
tranche in terms of its Attachment point and width, it is possible to customise the risk profile
of a tranche to the investor’s specific profile Attachment point: This is the amount of
subordination below the tranche. The higher the attachment point, the more defaults are
required to cause tranche principal losses and the lower the tranche spread. Figure 14 & Table
4 shows effect of spread rate on the Break even point. (CBE) Spread depends on the
following factors:-
a. Tranche width: The wider the tranche for a fixed attachment point, the more losses to
which the tranche is exposed. However, the incremental risk ascending the capital
structure is usually declining and so the spread falls.
b. Portfolio credit quality: The lower the quality of the asset portfolio, measured by
spread or rating, the greater the risk of all tranches due to the higher default
probability and the higher the spread.
c. Portfolio recovery rates: The expected recovery rate assumptions have only a
secondary effect on tranche pricing. This is because higher recovery rates imply
higher default probabilities if we keep the spread fixed. These effects offset each other
to first order.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

d. Swap maturity: This depends on the shapes of the credit curves. For upward sloping
credit curves, the tranche curve will generally be upward sloping and so the longer the
maturity, the higher the tranche spread.
e. Default correlation: If default correlation is high, assets tend to default together and
this makes senior tranches more risky. Assets also tend to survive together making the
equity safer. To understand this more fully we need to better understand the portfolio
loss distribution. Table 5 shows the effect of correlation on the CBE.
Table 4 Calculation of CBE for various tranche for different values of Rho

Equity 0-3 rho=10% rho=30% rho=70%

MC MC MC MC MC MC
Value st.dev Value st.dev Value st.dev

Floating leg value 2,292.42 2.56 1,771.89 3.57 931.79 3.77

10,844.2
Fixed leg value 6,657.61 11.12 8,258.19 13.52 2 12.87
Total Price with pre
defined coupon 1,959.54 3.06 1,358.98 4.19 389.57 4.38
Break Even coupon (CBE) 63.128% 0.216% 58.022% 0.2792% 35.156% 0.267%
Mezzanine 3-10 rho=10% rho=30% rho=70%
MC MC MC MC MC MC
Value st.dev Value st.dev Value st.dev

Floating leg value 1,516.19 6.14 1,515.42 7.23 1,162.22 7.27

Fixed leg value 28,811.0 13.97 28,190.03 19.75 28,484.6 22.25

Total Price with pre
defined coupon 75.64 6.79 105.92 8.15 (262.02) 8.04
Break Even coupon (CBE) 7.1857% 0.040% 11.301% 0.1005% 15.196% 0.169%
Senior 10-15 rho=10% rho=30% rho=70%
MC MC MC MC MC MC
Value st.dev Value st.dev Value st.dev

Floating leg value 111.22 1.77 354.66 3.48 542.89 4.49

Fixed leg value 22,314.7 2.53 21,798.50 8.04 21,135.8 12.82

Total Price with pre
defined coupon (1,004.5) 1.88 (735.26) 3.84 (513.90) 5.08
Break Even coupon (CBE) 0.6229% 0.011% 3.3341% 0.0547% 9.1068% 0.130%
Super Senior 15-30 rho=10% rho=30% rho=70%
MC MC MC MC MC MC
Value st.dev Value st.dev Value st.dev

Floating leg value 16.85 0.76 281.42 4.87 861.24 9.56

Fixed leg value 67,283.7 0.86 66,839.96 10.22 65,469.0 25.15

Total Price with pre

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 Exotic Credit derivatives and Lehman brothers: A case analysis

defined coupon (3,347.3) 0.80 (3,060.5) 5.35 (2,412.2) 10.72

Break Even coupon (CBE) 0.0266% 0.001% 0.6622% 0.0175% 3.6394% 0.072%

140.00%

120.00%

100.00%

80.00%
CBE %

CBE-1.5% Spread
60.00%
CBE-2.5% Spread
40.00%
CBE-3.5% Spread
20.00%

0.00%
-10% 10% 30% 50% 70% 90%
Correlation

Figure 14 Variation of CBE for change in Spread rate

Table 5 Price of pre-defined for variation in spread rate

Total price with pre Total price with pre Total price with pre
defined option@1.5% defined option@2.5% defined option
Correlation Spread Spread @3.5% Spread
10% (4,153.37) (1,999.89) 768.74
20% (5,093.28) (3,126.84) 1,803.45
30% (6,136.64) (4,355.87) 1,803.45
40% (6,941.09) (5,413.34) 3,999.31
50% (8,012.32) (6,343.96) 5,008.78
60% (8,766.73) (7,288.27) 5,989.30
70% (9,667.55) (8,250.81) 7,250.81
80% (10,307.18) (9,223.04) 8,323.16
90% (11,239.19) (10,304.99) 9,563.13

3.2.1 Analysis of the impact of Synthetic CDO on Lehman brothers:-Following were

some of the possible reasons that triggered the losses of Lehman brothers:-
a. Equity tranche which promised great returns has incurred great losses due to
the volatility in the market and this may be the possible reason behind the
losses of Lehman brothers.(Equity tranche is effected by 30-70% due to
changes in Rho value) Figure 15-18 shows the affect of rho value of various
tranches.
b. Most of the assets were occupied the lower correlation portions without
recognizing the composition of the tranche.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

c. Assets were purchased at the time of lowest interest regime/.However sub-

prime crisis causes the upward sloping curve which leads to the increase in
spread rate and this ultimately leads to the increase of default of assets.Futher
most of the assets taken as collatereral in equity tranche is in the anticipation
of increase in the value of the mortgages in case of default of lenders.
However this strategy backfired due to fall in assets price. This can be seen in
the effect of Rho on the equity tranche.
d. In this anticipation of the more returns width of the tranche also increased
(Equity, Mezzanine tranche).This resulted in more defaults.

Equity CBE
70%

60%

50%

40%
CBE

30%

20%

10%

0%
10% 30% 70%
Rho

Figure 15 CBE values of Equity tranche for variation in Rho

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 Exotic Credit derivatives and Lehman brothers: A case analysis

Senior CBE
10%

9%

8%

7%

6%
CBE

5%

4%

3%

2%

1%

0%
10% 30% 70%
Rho

Figure 16 CBE values of Senior tranche for variation in Rho

Mezzanine CBE
16%

14%

12%

10%
CBE

8%

6%

4%

2%

0%
10% 30% 70%
Rho

Figure 17 CBE values of Mezzanine tranche for variation in Rho

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 Exotic Credit derivatives and Lehman brothers: A case analysis

Super Senior CBE

4.0%

3.5%

3.0%

2.5%
CBE

2.0%

1.5%

1.0%

0.5%

0.0%
10% 30% 70%
Rho

Figure 18 CBE values of super senior tranche for variation in Rho

3.3 Valuation of credit options:- Valuation of credit options depends price, yield or credit
spread. The exercise price is constant for options struck on price, but for options struck on
yield it depends on the time to maturity of the underlying bond and has to be determined from
a standard yield-to-maturity calculation curve. Bond options struck on spread are different.
For credit spread options the exercise price depends both on the time to maturity of the bond
and on the term structure of interest rates at the exercise time. A credit spread strike is
commonly specified as a yield spread to a Treasury bond or interest rate swap, or as an asset
swap spread. credit spread strike is commonly specified as a yield spread to a Treasury bond
or interest rate swap, or as an asset swap spread. Option payoff after time‘t’ is

Where the PV01T is the value at T of a risky 1bp annuity to time TM or default, and ST is the
market spread observed at T on a CDS with maturity TM.
If suppose two assets A& B whose ratio of payments after time t equal to present ratio of
present payments then if Suppose A be the swaption, in which case AT is 0 if default
happens before T and PST otherwise. The value of the swaption today is then the value of the
swaption today is

If we make the assumption that log (ST) is normally distributed with variance σ2T,
corresponding to the spread following a log-normal process with constant volatility σ, then

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 Exotic Credit derivatives and Lehman brothers: A case analysis

with the requirement E(ST) = F0 (the forward spread), we have determined the distribution of
ST to be used to find E[max{ST –K,0}]. It is easy to calculate this expectation and we arrive
at the Black formula

Table 6 Valuation of Receiver default swap

Receiver default swaption:-

Buyer (Lehman brothers) Seller (FI)
Type of contract Short by the seller (FI)
Time 3 months
PV 4.39
Premium 120 BP to be paid by Lehman brothers
Scenarios:-
(I).Spread >265 BP Not exercise (Loss only Gets 120 BP paid by Lehman
be premium) and can retain option.
(II).Spread <265 BP Exercise up to Break up Receives only premium
point
(III).Spread below break up Loss is more for Lehman ----
brothers

Table 7 Products of default swaption

Product Payer default swaption Receiver default swaption

Description Option to buy protection Option to sell protection

Exercised if CDS spread at expiry > strike price CDS spread at expiry < strike price
Credit view Short credit forward Long credit forward
Knockout May trade or without Not relevant

3.3 Valuation of Basket default swap:- This type of products are based on redistributing
the credit risk of a portfolio of single name credits across a number of different securities.
The portfolio may be as small as five credits or as large as 200 or more credits. The
redistribution mechanism is based on the idea of assigning losses on the credit portfolio to the
different securities in a specified priority, with some securities taking the first losses and
others taking later losses. This exposes the investor to the tendency of assets in the portfolio
to default together, i.e., default correlation. The simplest correlation product is the basket
default swap. air-value of spread paid by a credit risky asset is determined by the probability
of a default, times the size of the loss given default. FTD baskets leverage the credit risk by
increasing the probability of a loss by conditioning the payoff on the first default among
several credits. The size of the potential loss does not increase relative to buying any of the
assets in the basket. The most that the investor can lose is par minus the recovery value of the

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 Exotic Credit derivatives and Lehman brothers: A case analysis

FTD asset on the face value of the basket. Value of n: An FTD (n=1) is riskier than an STD
(n=2) and so commands a higher spread. The other factor affects the correlation sensitivity is
the default probability of premier leg & Protection leg. Following affects the valuation of
Basket default swap.
a. Number of credits: The greater the number of credits in the basket, the greater the
likelihood of a credit event, and so the higher the spread.
b. Credit quality: The lower the credit quality of the credits in the basket, in terms of
spread and rating, the higher the spread
c. Recovery rate: This is the expected recovery rate of the nth-to-default asset
following its credit event. This has only a small effect on pricing since a higher
expected recovery rate is offset by a higher implied default probability for a given
spread. However, if there is a default the investor will certainly prefer a higher
realised recovery rate.
d. Default correlation: Increasing default correlation increases the likelihood of
assets to default or survive together. The effect of default correlation is subtle and
significant in terms of pricing.
3.5 Valuation of Hybrids:-The behaviour of hybrid credit derivatives is driven by the joint
evolution of credit spreads and other market variables such as interest and exchange rates
default protection on the MTM of an interest rate swap. Suppose an investor has entered into
a receiver swap with fixed rate k with a credit risky counterparty. If the MTM of the receiver
swap, R St is positive to the investor at the time of default, this is paid by the protection seller.
If RS t is negative, the investor receives nothing, so that the payoff at default is max (RSt, 0).
This is an option to enter into a receiver swap with fixed rate k for the remaining life of the
original trade at default. For simplicity, we assume that default can only take place at times ti.
If B denotes the price process of the savings account, then computing the expected
discounted cash flows gives the value V0 for the price of the default protection, where

This means that the value of default protection is a probability weighted strip of receiver
swap, where each swap is priced conditional on default happening at t.The parameters needed
for pricing hybrids are essentially volatility and dependence parameters.
Main factors required for pricing the product are
a. Calibration of volatilities
b. Determination of dependency between credit spreads and other market variables
c. Correlation between rate and credit process

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 Exotic Credit derivatives and Lehman brothers: A case analysis

4 Conclusions& Recommendations
4.0 Based on the valuations and pricing of the exotic credit derivative products following
conclusions can draw.
a. Portfolios have to be more diversified for avoiding the risk involved in the credit
derivative instruments. This can be understandable considering the risk exposure
to the various assets lesser/negative correlations can reduce the market effect on
the Portfolio. However care has to taken while designing the product.
b. More quantitative techniques has to applied for deriving the better results
c. Investors have to under stand the risk involved in the credit products and have to
evaluate the Quality of the assets before investing in the Portfolio.
d. Role of the rating agencies has to more regulated for avoiding the over rating of
the assets.
e. Application of better risk practices.

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 Exotic Credit derivatives and Lehman brothers: A case analysis

5. References
1. Collateral damage: Facing robust actions in the face of growing crisis.BCG Report
Oct 08
2. Investment and capital markets Market report second Quarter 2008:BCG Report
3. Lehman brothers guide to exotic credit derivatives
4. Options futures and other derivatives by John C.Hull
5. Wikipedia.com
6. www.google.com-General searches on credit derivatives in google

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