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Payments under a Credit Event

There is some initial reference price, either a nominal value for a loan, or a bond price reflecting the current credit standing of the issuer as well as the contractual payments of this asset. Since listed assets do not have a single price, several dealers' quotes serve for determining a price. Payments relate to the current value of the asset.

For traded assets, the post-default price defines the loss under default, a standard practice of rating agencies for publishing LGD. With total return swaps, payments cumulate the capital appreciation or depreciation with the normal asset return. For credit-spread derivatives, the payments are a function of the difference between initial and final credit spreads needs conversion into a value. The value is the difference in spreads times a multiple for converting this change into a price change. The multiplier is the duration since it measures the price sensitivity of a bond to a unit change in discount rate.

The relationship to the asset does not imply matching the asset price with the derivative notional. Users can leverage the actual exposure of the underlying by using a notional different from the actual asset value. This allows customizing the exposure. Lenders can reduce their excess exposure. Investors in credit derivatives can leverage their investments and customize their expected return. Delivery is in cash, or with securities considered as acceptable substitutes of the defaulted asset.

Credit Events

For trading such instruments, credit events triggering a credit derivative and payments once triggered have to be defined in a standard way.

Credit events triggering a credit derivative are not identical to those related to the underlying asset. In general, credit events have a wider scope than default events. For the reference asset, credit events include: payment obligation default, bankruptcy or insolvency event, restructuring or equivalent, rating downgrades beyond a specified threshold, and change of credit spread exceeding a specified level. Failure to pay is a default event. Not all such events are necessary for triggering a credit derivative payment. A subset of those events might be enough for triggering a credit derivative.

Events that trigger exercise of the derivative obligations overlap with the credit events of the reference asset, but might differ in practice. For example, any deterioration of the credit standing of the underlying asset might serve for triggering the derivative obligations. Mergers or split-offs might weaken the credit standing of firms and might be looked at as a potential relevant event for a credit derivative. Basel 2 specified the conditions for credit derivatives to be recognized as valid credit risk protection allowing relief of capital charges[1].

§ 191. In order for a credit derivative contract to be recognized, the following conditions must be satisfied:

(a) The credit events specified by the contracting parties must at a minimum cover:

Failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);

Bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and

Restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that result in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account).

§193. Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition.

The main credit events triggering payment are default, restructuring of debt or bankruptcy. The payment under default is the loss given default of the underlying asset.

Materialization

Such events might be uneasy to define precisely, because of potential disputes. Materiality clauses help to avoid triggering a "false" credit event by specifying the observable consequences of a credit event. Common facts are minimum variations of prices or changes in spreads, legal notices, and publicly available information. Price materiality refers to a minimum difference between the initial price of the reference asset and the current price. Spread materiality refers to a minimum difference between the spread at inception and the final spread.

PRICING CREDIT DERIVATIVES

A credit derivative, such as the common CDS, is similar to an option because it has a contingent leg, which is the payment contingent on default of the reference asset. The pricing mechanism is based on modeling the time to default of the derivative using time intensity models. The recurring premium should be equal to the expected value of the contingent leg. Time-to-default models[2] allow modeling directly the expected value of the random leg. Through such a pricing mechanism, it can be shown that the recurring premium should be theoretically identical to the credit spread of the underlying asset.

Some pricing issues remain difficult to address. Any correlation between the credit risk of the seller of protection and the issuer of the reference assets weakens the value of the protection because the likelihood of joint default is higher. The issue is identical with any insurer of credit risk. In other words, entering into a CDS does not fully eliminate the credit risk. There can be a joint adverse credit event (downgrade or default) of the underlying asset and of the seller of protection. The joint risk depends on correlation of credit events of obligor and seller of protection and is low as long as credit events do not correlate positively and significantly.

  • [1] Paragraph references are those of the main Accord document [7].
  • [2] Time-to-default models are explained in Chapters 10, 12 and 43.
 
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