1. FIN344: Credit Risk Management
Topic 7: Credit Derivatives and their Role in Credit Risk Management
Presented by Darren O’Connell

2. 2
Disclaimer
• The views expressed are those of the presenter,
and may not reflect those of Kaplan OHE.
• Use of information contained in this presentation
is at your own risk. The presenter recommends
you seek independent professional advice prior
to making any investment decisions.
• The information in this presentation is not
intended as investment advice. The presenter is
not offering or making recommendations in
relation to securities or other financial or
investment products.

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Subject & Topic learning outcomes
• On completion of this topic, students should be able to:
- Compare and contrast various financial instruments, in
particular structured products
- Explain the credit risk implications of each of these products
- Understand the family structure of securitised assets and
how they are valued
- Explain the structure of synthetic products and what
advantages these offer investors and risk managers
- Discuss the market evolution of these products over the
past decade
• This topic specifically addresses the following subject
learning outcomes:
4. Evaluate credit derivatives and how they are used in a range
of different scenarios.
5. Analyse a range of credit products.

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1.0 Credit Derivatives
• Credit derivatives (CDs) insure and protect against adverse
movements in the credit quality of the counterparties or borrowers.
• If a borrower defaults, the investor will suffer a loss on the investment.
• With CDs, losses suffered from a default will be offset by a
corresponding gain from the CD transaction.
• CDs offer lower transactions costs, quicker payment and greater
liquidity compared to a comparable product in the insurance market.
• CDs were initially invented to hedge an offsetting position in the
physical market, but now trading includes speculators which led to
CDs being a superior product to reducing credit risk compared to
traditional insurance.
• CDs are OTC products which are privately negotiated instruments and
thus lie somewhere between traditional credit insurance products and
exchange traded derivatives.

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Credit Derivatives (cont.)
• There are risks associated with using OTC CD contracts. These
include:
-Counterparties (the one offering the derivative);
-Liquidity (being unable to find a counterparties to offset the derivative
contract);
-Legal risk (the OTC CD contract may not be enforceable); and
-Valuation (CDs have many and varied valuation mechanisms which
make them hard to market or evaluate for two-way pricing).
• Most markets for derivatives assume risk neutrality and arbitrage
free conditions which may not necessarily exist for credit products
due to the unique bilateral situation between borrower and lender.
• By allowing credit risk to the freely traded, risk management of a
credit portfolio becomes far more flexible.

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Credit Derivatives (cont.)
• For valuation, CDs are classified into two main
categories:
-Replication products: priced on the capacity to replicate a money
market transaction (e.g. Credit spread options).
-Default products: priced as a function of the exposure underlying the
security, the default probability of the reference asset, and the expected
recovery rate (e.g. Credit default swaps).
• Other classifications include protection-like products
(e.g. Credit default options); and exchange-like products
(e.g. Total return swaps).
• We consider a selection of credit derivatives in more
detail.

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1.1 Total Return Swaps (TRS)
• In a TRS, the buyer receives the
income and capital gain of a credit
asset.
• The TRS seller receives a set fee
from the buyer over the life of the
swap.
• If the price of the asset declines then
the buyer must compensate the
seller by the lost amount.
• The TRS allow the buyer to gain
exposure and benefit from a credit
asset without the ownership.
• The TRS is popular with hedge funds
because they get the benefit of a
large exposure with a minimal cash
outlay.

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1.2 Credit Default Swaps (CDSs)
• A CDS is a financial agreement that the seller compensates the buyer
(the creditor of the reference loan/bond) in the event of default (by the
debtor).
• The buyer makes a series of payments (a "fee" or "spread") to the
seller and receives a payoff if the loan defaults.
• This effectively removes the need for specific insurance and is cheaper.
• If ‘No Default’:
- The protection buyer pays quarterly to the seller until maturity.
• If ‘Default Occurs’:
- The protection seller pays par value of the bond to the buyer; and
- The buyer transfers ownership of the defaulted bond to the seller.
• Maturities range from one to ten years.
• CDS data can be used by third parties to monitor how the market views
credit risk of any entity on which a CDS is available, this is similar to
that provided by the Credit Rating Agencies.

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1.3 Credit Linked Notes (CLNs)
• A CLN is a form of funded derivative
backed by a high quality asset such as
a US Treasury bond.
• It also contains an embedded credit
default swap allowing the transfer of
specific credit risk to investors.
• The note issuer is not obligated to
repay the debt is a specific event of
default occurs.
• CLNs pass the risk of specific default
onto investors willing to bear that risk
in return for higher rates of return.
• CLNs are issued by a SPV company
or trust, designed to offer investors par
value at maturity unless the referenced
entity defaults. In the case of default,
the investors receive a recovery rate.
• CLNs have been subject to fraud and
other malfeasance (e.g. Parmalat)

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2.0 Common Structured Products

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2.1 Collateralised Debt Obligations (CDOs)
• A CDO is an important class of ABS and MBS.
• Think of it as a promise to pay investors in a
pre-determined way, based on the cash flow
the CDO collects from the pool of bonds or
other assets it owns.
• It is sliced into "tranches“ based on credit
quality, which "catch" the cash flow of interest
and principal payments.
• If some loans default and the cash collected by
the CDO is insufficient to pay all of its investors,
those in the lowest tranches suffer losses first.
• The last to lose payment from default are the
safest, most senior tranches.
• Consequently interest rates and payments vary
by tranche with the safest tranches paying the
lowest rates of return and the lowest tranches
paying the highest rates - this compensates for
the risk of default across the tranches.

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2.2 Collateralised Loan Obligations (CLOs)
• Under a CLO payments from multiple business loans are pooled and
are passed on to different classes of investors in various tranches.
• The loans are multi-million dollar syndicated loan originated by a bank
which then discharges it off the balance sheet through a CLO.
• CLOs were “invented” to increase the liquidity of the investor pool
thereby lowering the cost of borrowing to businesses.
• They also allow for lower quality loans to exit the balance sheet (of a
bank) which then diverts capital into higher quality assets.
• A CLO consists of “tranches” which are layers of investments
differentiated by credit quality.
• The lowest class of investor bears the greatest risk of default but do, on
average, receive the highest rate of interest income.
• By pooling loans into tranches, diversifies risk and return in the one
vehicle.
• Firms with bad or no ratings can borrow cheaply through CLOs.

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2.3 Synthetic CDOs and CLOs
• Synthetic CDOs do not rely on the cash flows of the collateral asset
(e.g. Mortgage) pool.
• Instead, credit derivatives are used to link the performance of
securities issued by the SPV to the performance of some reference
pool of assets (e.g. An MBS index).
• There is no asset sale under a synthetic CDO, they stay on the
originator’s balance sheet;
• Such synthetic structures involve triggers based on:
- Ratings distributions;
- Diversity scores;
- Collateral values;
- Losses;
- Defaults.
• These triggers are structural elements providing protection to note
holders, comparable to coverage tests.

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3.0 Market Observations
• Up to 2007 there was an
abundance of cheap money
available for financing all kinds
of assets.
• Too much money chasing too
few deals e.g. Subprime
mortgages.
• Investment grade CDOs
offered returns far greater than
other investment grade assets.
• For example, in 2006 BBB-
rated CDOs yielded up to 900
basis points above LIBOR or
about 13% return per annum.

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3.0 Market Observations
• During the GFC demand for CLOs
tumbled markedly from the Q1
2007 peak.
• During 2008 there were virtually
no new issues of CLOs.
• During 2012, the issuance of
CLOs has increased to around
US$55 billion, a level not seen
since Q2 2005.
• In 2013 alone this had increased
to $US82 billion last seen in Q4
2005.
• Whether CLO issuance will repeat
its 2007 performance remains to
be seen.

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4.0 Summary
• In this topic we considered credit derivatives and their
application to credit risk management.
• We examined a number of popular products such as
-Total Return Swaps (TRS);
-Credit Default Swaps (CDS);
-Credit Linked Notes (CLN);
-Collateralised Debt Obligations (CDO);
-Collateralised Loan Obligations (CLO); and
-Synthetic CDOs and CLOs.
• We considered the growth in credit derivatives from 2006
and how the GFC impacted the need for credit protection.
• Topic 8 considers the management of credit risk on a
portfolio basis.

17. Thank you and good luck!