Credit Risk: From Transaction to Portfolio Management

Credit options have strong appeal to institutional investors as a

source of yield enhancement, generating exposure to a credit where the

bond is unavailable – the investor is short a credit collecting income in

return for the risk of losing an asset in the future (in the case of a call).

Other users of credit options are banks and dealers who seek to hedge

their marked to market exposure to variations in credit spreads. As

these institutions run leveraged balance sheets the off balance sheet

nature of the position created by a credit option is attractive.

3.9 Credit linked note

Credit linked notes (or CLNs) allow exposure to a credit in funded form.

It seems to the investor like a conventional credit bond. But behind

the façade is a subtle piece of financial engineering. They are com-

monly packaged within the debt issued by an SPV (Figure 3.17). The

vehicle enters into a default swap arrangement with a counterparty

buying protection. This resulting premium is passed on to the investor

who consequently has an enhanced yield relative to the risk free rate.

The SPV uses the funding to secure collateral. In the event of a credit

event the collateral is used to make the compensating payment to the

protection buyer. The investor bears the credit risk on both the refer-

ence entity and the collateral.

3.10 First to default

These types of credit derivatives have increased in popularity mainly

due to the fact that the investor can leverage their credit exposure,

160 Credit risk: from transaction to portfolio management

SPVDealer

High grade

securities

Investor

Contingent

payment

Protection

payment

Par

Par or recovery

value

L  x bps

Credit risk transfer

Par

Figure 3.17 Note issued by SPV.

without increasing their downside beyond the first name that defaults.

Further the premium received will usually be much higher than sell-

ing protection on just one name. A very recent development has been

the supply of index swaps, which pay the return received on a standard

index in return for a floating periodic payment. These are obviously

popular enabling an unfunded exposure to a wide variety of, potentially,

diverse credits.

A first to default note will consist of exposure to a number of credits

with the size being the notional at stake. After the first credit event the

note terminates and the investor must pay the protection seller either

a compensating one-of-payment (cash settlement). Or receive the ‘dam-

aged basket’ and make good the difference between this and par.

In Figure 3.18 the note is written on the three corporates whose yields

are depicted in the figure. We can see that Corp C defaults which would

trigger settlement.

The note will either be cash settled or physically settled in which case

the owner of protection will deliver the damaged asset in return for

par. This is often the case for first to default notes issued by an SPV.

The amount for cash settlement is the difference between par and the

final price of the reference obligation.

The yield that the investor receives on a first to default spread note

will be somewhere between the spread of the worst individual credit and

the sum of the spreads on all. This will be close to the sum of spreads

if the correlation is low and vice versa for high correlation. The reason

for this is that in the case of no correlation the portfolio will have the

properties of a sum of individuals while if they are all correlated they

effectively behave as the worst asset. Figure 3.19 shows the first to

default spread curve and how it depends on correlation. The first to

default spread is equal to the worst in the case where the correlation

is equal to 100 per cent.

Credit derivatives 161

0

5

10

15

20

25

30

Yield (%)

Time (years)

12345678910

Corp A

Corp B

Corp C

Figure 3.18 The yields on three companies (% vs. Time).