Pricing

Credit trades at different spread levels in different product sectors. The spread in the
corporate bond market may differ from the loan market, and each may differ from
the spread available in the credit derivatives market. Indeed, credit derivatives allow
institutions to arbitrage the different sectors of the credit market, allowing for a more
complete market.
With an asset swap, an investor can synthetically transform a fixed-rate security
into a floating rate security, or vice versa. For example, if a corporate bond trades at
a fixed yield of 6%, an investor can pay a fixed rate on an interest rate swap (and
receive LIBOR), to create a synthetic floater. If the swap fixed rate is 5.80%, the
floater yields LIBOR plus 20 basis points. The spread over LIBOR on the synthetic
floater is often compared to the market price for a default swap as an indicator of
value. If the fee on the default swap exceeds, in this example, 20 basis points, the
default swap is ‘cheap’ to the asset swap, thereby representing value.
While benchmark indicators are convenient, they do not consider all the factors a
bank should evaluate when selling protection. For example, when comparing credit
derivative and cash market pricing levels, banks should consider the liquidity disadvantage
of credit derivatives, their higher legal risks, and the lower information
quality generally available when compared to a direct credit relationship.
Using asset swap levels to determine appropriate compensation for selling credit
protection also considers the exposure in isolation, for it ignores how the new
exposure impacts aggregate portfolio risk, a far more important consideration. The
protection seller should consider whether the addition of the exposure increases the
diversification of the protection seller’s portfolio, or exacerbates an existing concern
about concentration. Depending on the impact of the additional credit exposure on
its overall portfolio risk, a protection seller may find that the benchmark pricing
guide; i.e. asset swaps, fails to provide sufficient reward for the incremental risk
taken. Banks face this same issue when extending traditional credit directly to a
borrower. The increasing desire to measure the portfolio impacts of credit decisions
has led to the development of models to quantify how incremental exposures could
impact aggregate portfolio risk.

Speculation

Credit derivatives allow banks, for the first time, to sell credit risk short. In a short
sale, a speculator benefits from a decline in the price of an asset. Banks can short
credit risk by purchasing default protection in a swap, paying the total return on a
TRS, or issuing a CLN, in each case without having an underlying exposure to the
reference asset. Any protection payments the bank receives under these derivatives
would not offset a balance sheet exposure, because none exists.
Short positions inherently represent trading transactions. For example, a bank
may pay 25 basis points per year to buy protection on a company to which it has no
exposure. If credit spreads widen, the bank could then sell protection at the new
market level; e.g. 40 basis points. The bank would earn a net trading profit of 15
basis points.
The use of short positions as a credit portfolio strategy raises concerns that banks
may improperly speculate on credit risk. Such speculation could cause banks to lose
the focus and discipline needed to manage traditional credit risk exposures. Credit
policies should specifically address the institution’s willingness to implement short
credit risk positions, and also specify appropriate controls over the activity.

Managing leverage considerations

Most credit derivatives, like financial derivatives, involve leverage. If a bank selling
credit protection does not fully understand the leverage aspects of some credit
derivative structures, it may fail to receive an appropriate level of compensation for
the risks assumed.
A fixed payout (or binary) default swap can embed leverage into a credit transaction.
In an extreme case, the contract may call for a 100% payment from the protection
seller to the protection buyer in the event of default. This amount is independent of
the actual amount of loss the protection buyer (lender) may suffer on its underlying
exposure. Fixed payout swaps can allow the protection buyer to ‘over-hedge’, and
achieve a ‘short’ position in the credit. By contracting to receive a greater creditevent
payment than its expected losses on its underlying transaction, the protection
buyer actually benefits from a default. Protection sellers receive higher fees for
assuming fixed payment obligations that exceed expected credit losses and should
always evaluate and manage those exposures prudently.
For a protection seller, a basket swap also represents an especially leveraged credit
transaction, since it suffers a loss if any one of the basket names defaults. The
greater the number of names, the greater the chance of default. The credit quality of
the transaction will ordinarily be less than that of the lowest rated name. For
example, a basket of 10 names, all rated ‘A’ by a national rating agency, may not
qualify for an investment grade rating, especially if the names are not highly correlated.
Banks can earn larger fees for providing such protection, but increasing the
number of exposures increases the risk that they will have to make a payment to a
counterparty.
Conceptually, protection sellers in basket swaps assume credit exposure to the
weakest credit in the basket. Simultaneously, they write an option to the protection
buyer, allowing that party to substitute another name in the basket should it become
weaker than the originally identified weakest credit. Protection buyers in such
transactions may seek to capitalize upon a protection seller’s inability to quantify
the true risk of a default basket. When assuming these kinds of credit exposures,
protection-selling banks should carefully consider their risk tolerance, and determine
whether the leverage of the transaction represents a prudent risk/reward
opportunity.

Evaluating credit protection

Determining the amount of protection provided by a credit derivative is subjective,
as the terms of the contract will allow for varying degrees of loss protection. Manage
ment should complete a full analysis of the reference obligor(s), the counterparty, and
the terms of the underlying credit derivative contract and document its assessment of
the degree of protection. Table 11.5 highlights items to consider.

Banks selling credit protection assume reference asset credit risk and must
identify the potential for loss, they should risk rate the exposure based on the
financial condition and resources of the reference obligor.
Banks face a number of less obvious credit risks when using credit derivatives.
They include leverage, speculation, and pricing risks.

Evaluating counterparty risk

A protection buyer can suffer a credit loss on a default swap only if the underlying
obligor and the protection seller simultaneously default, an event whose probability
is technically referred to as their ‘joint probability of default’.
To limit risk, credit-hedging institutions should carefully evaluate the correlation
between the underlying obligor and the protection seller. Hedgers should seek
protection seller counterparties that have the lowest possible default correlation with
the underlying exposure. Low default correlations imply that if one party defaults,
only a small chance exists that the second party would also default. For example, a
bank seeking to hedge against the default of a private sector borrower in an emerging
market ordinarily would not buy protection from a counterparty in that same
emerging market. Since the two companies may have a high default correlation, a
default by one would imply a strong likelihood of default by the other. In practice,
some credit hedging banks often fail to incorporate into the cost of the hedge the
additional risk posed by higher default correlations. The lowest nominal fee offered
by a protection seller may not represent the most effective hedge, given default
correlation concerns. Banks that hedge through counterparties that are highly
correlated with the underlying exposure should do so only with the full knowledge of
the risks involved, and after giving full consideration to valuing the correlation costs.

Managing maturity mismatches

A bank purchasing credit protection is exposed to credit risk if the maturity of the
credit derivative is less than the term of the exposure. In such cases, the bank would
face a forward credit exposure at the maturity of the derivative, as it would no longer
have protection. Hedging banks should carefully assess their contract maturities to
assure that they do not inadvertently create a maturity mismatch by ignoring material
features of the loan. For example, if the loan has a 15-day grace period in which the
borrower can cure a payment default, a formal default can not occur until 15 days
after the loan maturity. A bank that has hedged the exposure only to the maturity
date of the loan could find itself without protection if it failed to consider this grace
period.
In addition, many credit-hedging transactions do not cover the full term of the
credit exposure. Banks often do not hedge to the maturity of the underlying exposure
because of cost considerations, as well as the desire to avoid short positions that
would occur if the underlying obligor paid off the bank’s exposure. In such cases,
the bank would continue to have an obligation to make fee payments on the default
swap, but it would no longer have an underlying exposure.

Managing basis risk

The purchase of credit protection through credit derivatives may not completely
eliminate the credit risk associated with holding a loan because the reference asset
may not have the same terms and conditions as the balance sheet exposure. This
residual exposure is known as basis risk. For example, upon a default, the reference
asset (often a publicly traded bond) might lose 25% of its value, whereas the
underlying loan could lose 30% of its value. Should the value of the loan decline
more than that of the reference asset, the protection buyer will receive a smaller
payment on the credit default swap (derivative) than it loses on the underlying loan
(cash transaction). Bonds historically have tended to lose more value, in default
situations, than loans. Therefore, a bank hedging a loan exposure using a bond as a
reference asset could benefit from the basis risk. The cost of protection, however,
should reflect the possibility of benefiting from this basis risk. More generally, unless
all the terms of the credit derivative match those of the underlying exposure, some
basis risk will exist, creating an exposure for the protection buyer. Credit hedgers
should carefully evaluate the terms and conditions of protection agreements to
ensure that the contract provides the protection desired, and that the hedger has
identified sources of basis risk.