Ch6 Credit Derivatives & Credit-Linked Notes (3)

4. Asset Default Swaps (ADS)
- Single-Name CDS
- Reference Entity = Asset-Backed Securities


5. Equity Default Swaps (EDS)
- Reference Asset = Stock
- Prespecified decline in the reference stock price (usually around 70%)
- Equity Event: market risk or price protection <-> Credit Event
- A type of deeply OTM equity Put (DOOM Options)
- Need not have an insurance interest - need not actually own the stock
- Resemble Down-and-in Put Option: http://www.investopedia.com/terms/d/daio.asp



e.g.) Stock price: $100, Equity event: 75% of the closing stock price, Recovery amount: 40%, Notional principal: $10M
=> fixed payment by EDS seller = $10M x * (100% - 40%) = $6M



6. Total Return Swaps (TRS)
6-1. Video lecture: http://www.youtube.com/watch?v=cmUXTFggIa0




6-2. Definition
A contract in which the protection seller pays LIBOR plus a spread to the protection buyer in exchange for receiving LIBOR plus a cash amount equal to all realized interest payments on the reference assets plus any change in the market value of the reference assets.
- protection: risk of defaults, declines in value (credit deterioration) or other adverse credit events (market risk)
- notional amount: may or may not be the same as the face value of the reference portfolio
- market value determination: by a contracted third party or by reference to an index
- protection seller: eliminating funding costs -> Funding Leverage
- TROR payers synthetically short the asset & TROR receiver synthetically long the asset


7. Credit-Linked Notes (CLN)
7-1. Definition: http://www.investopedia.com/terms/c/creditlinkednote.asp
CLN issuer issues a note or bond to CLN buyer. Investor (CLN buyer) in the note is the credit protection seller and is making an upfront payment to the protection buyer.


7-2. Structure, Benefit & Cost
- funded credit risk transfer instrument
- transferring default & credit deterioration risk to CLN buyer -> no counterparty risk

- if no defined events of default -> scheduled principal & interest payment (above market rate)
- if downgraded -> lower rate
- if a specified credit event occurs -> withhold interest & all or part of the principal = investor only gets the recovery (par value on the bond - recovery). Under cash settlement, CLN Issuer will pay the default value, or recovery value(RR), of the reference asset to the CLN buyer. this is equivalent to the [100 - RR] payout. Under physical settlement, CLN Issuer will deliver a note or bond to the CLN buyer.

- CLN Issuer (Protection Buyer): funded & no counterparty risk
- CLN buyer: yield enhancement but counterparty risk, credit risk, & correlation between default/counterparty risk of bond owner & reference assets is key factor for CLN buyer

- illiquid

7-3. Video lecture: http://www.youtube.com/watch?v=mxNMEtchKd8

8. Tranched Basket Default Swap (TBDS)

- A synthetic CDO
- SPV sells credit protection on assets in the reference basket: credit risk is transferred from asset owners to the SPV synthetically via CDS
- Investors purchase tranched securities
- Cash is invested into safe assets
- The junior tranche absorbs the first k number of defaults and the mezzanine is exposed from k+1 defaults (attachment point) to l defaults (detachment point)
- Investor: coupons on the safe assets plus CDS premium (spread)