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Credit Default Swap Price Data

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					Credit Derivatives - A Buyside Perspective



         Deutsche Bank Relative Value Summit
                   March 2-6, 2000

                       Ron D'Vari, Ph.D., CFA
Sr. Vice President, Portfolio Manager, and Director of Quantitative Research
              State Street Research & Management
                                           Credit Derivatives
             Transactions Most Actively Considered:
                    • Asset Swap
                    • Total Return and Index Swap
                    • Default Swap
             Other Credit Derivative Structures Under Consideration:
                    • Credit Linked Notes (CLNs)
                    • Credit Spread Option
                    • CBOs, CLOs, Synthetic CLOs
                    • Synthetic Leveraged Loan
                    • Synthetic Revolving Credit Agreements



State Street Research & Management, Ron D’Vari, Ph.D., CFA             2
                    Buyside Credit Derivative Strategies

             • Flexible Credit/Sector Exposure Tailoring
                 – Access: Sourcing names and maturities not available through
                   cash instrument market
                 – Flexibility: Uncoupling of interest and credit exposure
             • Diversification
             • Yield Enhancement
                 – Exposure to short maturities with low price sensitivity
             • Relative Value and Replication
                 – Cheaper synthetic cash positions
             • Hedging
             • Leverage or Financing


State Street Research & Management, Ron D’Vari, Ph.D., CFA                   3
                                          Buyside Challenges
          • Internal and External Education
          • Accurate Portfolio Analytics and Risk Models
          • Consistent Framework for Use In Portfolio Context
          • Infrastructure: Compliance, Trading, and Accounting Systems
          • Signing ISDA Agreements
               – Several hundred plan sponsors and separate accounts
               – Multiple dealers and banks
               – A dozen custodians
               – Legal resources
          • Shortcomings of the Standard Representations in ISDA
               – Not developed for investment managers acting as agent
               – Often impossible for managers to make
               – Requires involvement of plan sponsors and custodians
State Street Research & Management, Ron D’Vari, Ph.D., CFA                4
                  Portfolio Level Considerations of Credit Derivatives

          • Besides fundamental analysis of reference credit and counterparty
            overall portfolio suitability has to be established.
          • Optimal allotment of risk budget to credit derivatives
             – Portfolio’s total risk is budgeted to key active exposures
                Level and shape of term structure of interest rates
                Volatility
                Sector/Credit exposures (by sector by credit by maturity)
          • Risk Analysis and Its Transparency
             – Accurate accounting of credit derivatives in daily and intraday
               portfolios’ multi-factor absolute and relative risk reports
             – Measure credit, spread change, and structural risks
          • Quantitative Relative Value Framework
               – W.r.t. cash instruments or other forms of risk
          • Liquidity and Pricing
          • Infrastructure

State Street Research & Management, Ron D’Vari, Ph.D., CFA                   5
                                                 Infrastructure
          • Documentation
          • Trading
          • Counterparty Risk Management
          • Compliance
          • Accounting and Custodial




State Street Research & Management, Ron D’Vari, Ph.D., CFA        6
                                               Documentation
          • Limited Recourse
               – Sub-account managed by manager
          • Size Matters
               – No trigger with account size change
               – May require lower collateral threshold and minimum transfer
          • Collateralization
               – Eligibility
               – Threshold and minimum transfer amount
          • Manager Termination
               – Avoid early termination through assignment

          • Assignment
               – Both parties consent

State Street Research & Management, Ron D’Vari, Ph.D., CFA                     7
               Understanding Factors Impacting Prices
         • Changes in Credit Condition
         • Credit Spreads in Cash Market
         • Cost of Alternatives
         • Regulatory Capital Requirements
         • General Market Liquidity
         • Pricing Models
                   – Traditional Credit Judgment
                   – Quality of Historical Default Rates and Recoveries
                   – Availability and Quality of Historical Spread
                   – Availability of Volatility and Correlation data
                   – Credit Default Swap Curves
                   – Basis Between Credit Swap and Other Credit Pools
                   – Modeling Tranched Credit and Basket

State Street Research & Management, Ron D’Vari, Ph.D., CFA                8
              Buyside Use of Various Credit Derivatives
             Presentation Focus:
             • Asset Swap
             • Total Return and Index Swap
             • Default Swap




State Street Research & Management, Ron D’Vari, Ph.D., CFA   9
                                                   Asset Swap
                                             Coupon from Bond A

                SSRM                                                            Counter Party

                                    Some Index (Libor, CMT, fixed level etc.)
                                                  + Spread
  Coupon                  Market
  and                     Price
  Principle



               Bond A




         Motivation
        • Swap floating assets to fixed or vice versa
        • Trade away imbedded options in a bond or layer in options

State Street Research & Management, Ron D’Vari, Ph.D., CFA                                 10
                                  Index Total Return Swap
                                                     Index Sector Total Return

                SSRM                                                             Counter Party

                                                   Libor + Spread
                                                         or
   Holdings              Market            Total Return of Another Sector
   Total                 Price
   Return


         SSRM Holdings
           in a Sector

        Motivation
       • Adjust exposure without buying or selling individual securities
       • Hedging, Relative Value, Market access, Flexibility
       • Avoid paying bid-ask spread for a short dated trade
       • Get financing (leverage)
State Street Research & Management, Ron D’Vari, Ph.D., CFA                                  11
                Single Reference-Entity Credit Default Swap

            •    Transfer the credit risk of an issuer (reference entity) from one entity
                 (buyer) to another (seller)
            •    Seller of protection agrees to buy “obligations” of the reference
                 entity at par in the event of a public notice
            •    Default event is defined a “publicly available notice” to:
                   – A payment failure larger or equal than “Payment Requirement” on
                   – an obligation equal or larger than “Default Requirement”

            •    Settlement can be “Physical” or “Cash”
            •    Deliverable obligations can be
                   – Reference obligation
                   – Any of Deliverable obligations
                        • According to ISDA it could be any borrowed money: loans,cp, bond, and
                          bond and loan
                        • Must be specified in long confirm

State Street Research & Management, Ron D’Vari, Ph.D., CFA                                        12
    Advantages of Default Swap over Short Corporates

           •    In general they tend to be cheaper than similar cash bond because:
                  – buyers inability to hedge their risk in any other market
                      (shorting public debt can be quite risky and subject to adverse technicals)
                  –    expensive risk capital charges required against credit risk

           •    Increases yield with minimal increase in spread duration
                  – Very attractive break-even cushion against spread widening

           •    Ability to do default swap opens up unique opportunities to tailor
                credit exposure of the portfolio - i.e. take advantage of credit curve
                steepness (buy longer dated cash bonds and roll over short dated
                credit protection)
           •    More flexibility - Default swap does not tie up cash to earn spread
           •    Allows creating higher information ratio strategies that may be
                leveraged for higher returns than similar risk strategies
           •    Access to names and maturities that otherwise may not be available

State Street Research & Management, Ron D’Vari, Ph.D., CFA                                          13
                                         Pricing Methodology
    •    Method 1: Basis - Asset Swap vs. Default Swap (works only for single name)
    •    Method 2: Model Loss Distribution

                   Credit Spreads                                            Recovery Rates


                                                     Market Implied
                Asset Correlations
                                                   Default Probabilities


                                  Default Correlations



                                                                Simulator



                                                             Loss Distribution



State Street Research & Management, Ron D’Vari, Ph.D., CFA                                    14
                        Pricing Single-entity Default Swap
            •    Compare Libor spread of cash bond of the issuer of similar maturity
                 with the default swap rate
            •    Compare all-in yield of a synthetic bond of “Default Swap+AAA ABS”
                 with the cash bond
            •    Compare a given spread with valuation based on long-term default
                 probability and recovery rates based on transition probability matrix
                 and recovery value
                                                                          Default Option
                                                                          on $10mm TCI
                                                                             7 ¼ 6/99
                                                                                           COUNTER-
                                                 ACCOUNT                                    PARTY
                                                                          40BP/Annum



                                       Bond                       $10mm




                                               AAA Asset Back
                                                  Maturing
                                                   6/15/99
                                              (+20 to 25bp over
                                                 Treasury)



State Street Research & Management, Ron D’Vari, Ph.D., CFA                                            15
            Transition Probability (S&P CreditWeek 15 April 96)
          • Over 15 years of data with more than 25,000 firm/years of observations,
            adjusted for “no-longer rated” entities
                            Intial                           Rating At Year-End (%)
                            Rating
                                        AAA      AA          A    BBB      BB      B      CCC     D

                            AAA        90.81     8.33    0.68      0.06   0.12    0.00    0.00   0.00

                            AA          0.70    90.65    7.79      0.64   0.06    0.14    0.02   0.00

                            A           0.09     2.27    91.05     5.52   0.74    0.26    0.01   0.06

                            BBB         0.02     0.33    5.95     86.93   5.30    1.17    0.12   0.18

                            BB          0.03     0.14    0.67      7.73   80.53   8.84    1.00   1.06

                            B           0.00     0.11    0.24      0.43   6.48    83.46   4.07   5.20

                            CCC         0.22     0.0     0.22      1.30   2.38    11.24   64.86 19.79



               • Four sources of transition probability matrices: S&P, Moody,
                 CreditMetrix, KMV



State Street Research & Management, Ron D’Vari, Ph.D., CFA                                              16
            •Recovery rates (CreditMetrix using several studies)
                            Seniority Class                       Mean(%)                  Std. Dev. (%)

                       Senior Secured                                 53.80                     26.86

                       Senior Unsecured                               51.13                     25.45

                       Senior Subordinated                            38.52                     23.81

                       Subordinated                                   32.74                     20.18

                       Junior Subordinated                            17.09                     10.90


           •Average Cumulative Default Rates (%)
                                              Term          1          3         5       10    15

                                            AAA           0.00       0.07       0.24    1.40   1.40

                                            AA            0.00       0.12       0.43    1.29   1.48

                                            A             0.06       0.27       0.67    2.17   3.00

                                            BBB           0.18       0.72       1.78    4.34   4.70

                                            BB            1.06       6.12       10.97   17.73 19.91

                                            B             5.20      15.95 21.88         29.02 30.65

                                            CCC          19.79      31.63 40.15         45.10 45.10
                                           Source: S&P CreditWeek 15 April 96




State Street Research & Management, Ron D’Vari, Ph.D., CFA                                                 17
                    Simple Example of Breakeven Spreads

       •Annual Breakeven Spread
             (1-Spread)^n = (1- Cumulative Default Rate * Recovery Rate)
                      Annual Break-even Spread for Sr. Sec. Class (bp)          Annual Break-even Spread for Sr. Unsec. Class (bp)
             Term        1         3        5         10          15     Term      1         3        5         10          15
             AAA         0         1        2          6           4     AAA       0         1        2          7          5
             AA          0         2        4          6           5     AA        0         2        4          6          5
             A           3         4        6         10           9     A         3         4        7         11          10
             BBB         8         11       17        20          15     BBB       9         12       17        21          15
             BB          49        95      103        85          64     BB        52       101      110        90          68
             B          240       252      211       143         101     B        254       267      224       152         108
             CCC        914       513      402       231         155     CCC      967       544      427       246         165


                      Annual Break-even Spread for Sr. Sub. Class (bp)          Annual Break-even Spread for Sub. Class (bp)
             Term        1         3        5         10          15     Term      1         3        5         10          15
             AAA         0         1        3          9           6     AAA       0         2        3         9           6
             AA          0         2        5          8           6     AA        0         3        6         9           7
             A           4         6        8         13          12     A         4         6        9         15          14
             BBB         11        15       22        27          20     BBB       12        16       24        30          21
             BB          65       127      139       115          87     BB        71       139      152       126          95
             B          320       338      285       195         138     B        350       371      313       215         153
             CCC        1217      695      551       320         214     CCC      1331      766      610       355         238




State Street Research & Management, Ron D’Vari, Ph.D., CFA                                                                  18

				
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