Credit derivatives

Introduction

Credit derivatives emerged in the 1990s, and the market and the range of products have grown significantly since then. A credit derivative may be defined as "...a contract where the payoffs depend partly upon the creditworthiness of one or more commercial or sovereign entities."70 There are a number of credit derivative contracts, such as total return swaps (e.g. where the return from one asset is swapped for the return on another asset), credit spread options (e.g. an option on the spread between the yields on two assets; the payoff depends on a change in the spread) and credit default swaps. The latter is the most utilised credit derivative, and we focus on this one below.

Example of credit default swap

A credit default swap is a bilateral contract between a protection purchaser and a protection seller that compensates the purchaser upon the occurrence of a credit event during the life of the contract. For this protection the protection purchaser makes periodic payments to the protection seller. The credit event is objective and observable, and examples are: default, bankruptcy, ratings downgrade, and fall in market price.

Figure 2: example of a credit default swap

An example is required (default by an issuer of a bond): a credit default swap contract in terms of which INVESTCO Limited (an investor; called the protection buyer) has the right to sell a bond72 issued by DEFCO Limited (a bond issuer; called the reference entity) to INSURECO Limited (an insurer; called the protection seller) in the event of DEFCO defaulting on its bond issue (the specified credit event). In this event the bond is sold at face value (100%).

In exchange for the protection, the protection buyer undertakes to settle an amount of money (or fee) in the form of regular payments to the protection seller until the maturity date of the contract or until default. The fee is called the default swap spread. This contract may be illustrated as in Figure 2.

As noted, the fee is payable until maturity of the bond or until default. If default takes place, the protection buyer has the right to sell the bond to the protection seller at par value. It is then up to the protection seller to attempt to recover any funds from the defaulting bond issuer. The following are the details of the contract:

Protection buyer = INVESTCO Limited

Protection seller = INSURECO Limited

Reference entity (issuer) = DEFCO Limited

Currency of bond = ZAR

Maturity of bond = 3 years

Face value = ZAR 30 million

Default swap spread = 35 basis points pa

Frequency = Six monthly

Payoff upon default = Physical delivery of bond for par value

Credit event = Default by DEFCO Limited on bond.

Figure 3: cash flows with no default (to protection seller)

The cash flows in the event of no default and default are as shown in Figure 3 and Figure 4.

Figure 4: cash flows in event of default

Pricing

The pricing of credit derivatives is straightforward. The fee payable on the swap, i.e. the default swap spread (DSP), should be equal to the risk premium (RP) that exists over the risk-free rate (rfr = rate on equivalent term government bonds). In other words, the DSP should be equal to the RP which is equal to the yield to maturity (ytm) on the DEFCO bond less the rfr:

DSP = RP = ytm - rfr.

This is so if the credit default swap is priced correctly. If this is not the case, arbitrage opportunities arise. For example, if rfr = 10.0% pa and RP = 5.0% pa then ytm = 15.0% pa. If the market rate (ytm) of the reference bond is 17.0% pa, and DSP = 5.0% pa, it will pay an investor (protection buyer) to buy the bond at 17.0% pa and do the credit swap (cost = 5% pa) because he is getting a 200bp better return than the rfr (10% pa) on a synthetic risk-free security.

Conversely, if the ytm of the reference bond is 13.0% pa, and DSP = 5.0% pa, it pays the protection seller to short the reference bond and enter into the swap. This means that the protection seller is borrowing money at 13% pa (the ytm at which the reference bond is sold), and investing at the rfr (10.0% pa) and earning the DSP of 5.0% pa, i.e. a profit of 200 bp.

Clearly these examples point to the fact that arbitrage will ensure that in an approximate sense DSP = RP.

The main participants in the credit derivatives market are the banks (63% of protection buyers and 47% of protection sellers), securities firms (18% of protection buyers and 16% of protection sellers) and insurers (7% of protection buyers and 23% of protection sellers).75 The other participants are the hedge funds, mutual funds, pension funds, companies, government, and export credit agencies.