Pricing Portfolio Credit Derivatives by Means of Evolutionary Algorithms
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Pricing Portfolio Credit Derivatives by Means of Evolutionary Algorithms | Svenja Hager | Springer
The only exception to this should be Credit Linked Notes that are typically issued as bonds and are, therefore, subject to the documentation requirements of bonds. However, the suggested documentation should be agreeable by both the parties. In the case of credit derivatives, exposure for a specific credit derivative will be driven mainly by whether the holder of the credit derivative is the protection buyer or the protection seller. Conversely, the protection seller's exposure would increase as the protection seller acquires what is equivalent to a credit exposure on the reference asset.
Sufficient provisioning as computed based on what would be the provisioning applicable if the reference asset were on the seller's books would have to be carried out by the credit protection seller if it is offering credit protection on a non performing asset. The protection buyer should not make any provision for a reference asset that has turned to NPA. For capital adequacy purposes, the banks should adopt an approach similar to the guidelines for existing credit transfer products such as financial guarantees.
The normal accounting entries for credit derivative transactions should be fairly straightforward depending on cash flows that take place at various points in time during the tenor of the transaction, e. However, all derivatives within the scope of the standard must be fair valued at least on a quarterly basis. Ghosh Member.
Joydeep Sengupta Member Mrs. Kar Member. Mahapatra Convenor. The credit default swaps CDS have grown rapidly in the credit risk market since their introduction in the early s. It is believed that current usage is but a small fraction of what it will ultimately represent in the credit risk markets. In particular, the CDS market will become as central to the management of credit risk as the interest rate swap market is to the management of market risk.
In a CDS, as shown below in Figure 1, one party agrees to pay another party periodic fixed payments in exchange for receiving 'credit event protection', in the form of a payment, in the event that a third party or its obligations are subject to one or more pre-agreed adverse credit events over a pre-agreed time period. With few exceptions, the legal framework of a CDS — that is, the documentation evidencing the transaction — is based on a confirmation document and legal definitions set forth by the International Swaps and Derivatives Association, Inc.
Figure 2 pictorially shows the transactions under a cash settled CDS. On periodic interim dates, Protection Buyer pays to Protection Seller pre-agreed amounts; and. If a Credit Event does not occur, no further payments are made at maturity; or. If a Credit Event occurs and physical settlement applies, the transaction shall accelerate and Protection Buyer shall deliver the Deliverable Obligations defined below to Protection Seller against payment of a pre-agreed amount; or.
If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and Protection Seller shall pay to Protection Buyer the excess of a the par value of the Deliverable Obligations on start date over b the prevailing market value of the Deliverable Obligations upon occurrence of the Credit Event. The procedure for determining market value of Deliverable Obligations is defined in the ISDA definitions or may be defined in the related Confirmation , or a pre-determined amount agreed by both parties on inception of the transaction.
Contingent settlement, which is triggered by a Credit Event, can be calculated in several ways. Settlement options include:. Usually includes Reference Obligation but will often be broader to include other Obligations.
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Uses and Benefits of Credit Default Swaps. Effective tool for hedging against changes in Credit Spreads - Default swaps are dynamic, market-sensitive products whose mark-to-market performance is closely related to changes in credit spreads. As a result, they are an effective tool for hedging or for assuming exposure to changes in credit spread as well as default risk.
Ability to create custom maturity products - An investor wants a three-year maturity and duration exposure to an issuer that has only 2-year and year securities outstanding.
Pricing Portfolio Credit Derivatives by Means of Evolutionary Algorithms
Selling a three-year Default Swap on the year security can create the required exposure. In effect, the investor will have taken on the credit risk for the duration of the swap, i. Management of concentration of credit risk within credit portfolios - An investor who owns a portfolio of credits can alter the concentration risk of their portfolio by buying or selling credit risk on different names and varying maturities by using credit default swaps. Management of credit limits - For banks that have loans or transactions with counterparties that require further funding but are constrained because of internal or regulatory credit limits, credit default swaps can allow the bank to reduce the credit exposure to that counterparty without damaging the business relationship.
CDS premium quotations are typically in basis points per year. The cash market equivalent would be the credit spread over Government bonds at which a given corporate trades, e. If a counterparty seeks to go short credit risk i. Therefore, the credit spread over risk-free assets e. Government of India bonds of equal tenor are a good indication of where the CDS premium on an asset will trade.
The reasons that the CDS premium will not be exactly equal to the credit spread include:. It is, a combination of a regular note bond or deposit and a credit-option.
Since it is a regular note with coupon, maturity and redemption, it is an on-balance sheet equivalent of a credit default swap. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk and investors a higher yield for buying a credit exposure synthetically rather than buying it in the publicly traded debt. CLNs can also be issued directly by a bank or financial institution or non-banking finance company. Investors buy the securities from the trust or issuing bank that pays a fixed or floating coupon during the life of the note.
At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. Here the investor is, in fact, selling the credit protection in exchange for higher yield on the note. If the issuer is a trust, it enters into a default swap with a deal arranger. In the case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee.
This annual fee is passed on to the investors in the form of a higher yield on the notes.
In this structure, the investors can obtain higher yield for taking the same risk as the holder of the underlying reference credit. The investor does, however, take the additional risk, albeit limited, of its exposure to the AAA-rated trust or issuing bank. The Credit-Linked Note allows a bank to lay off its credit exposure to a range of credits to other parties. Conceptually they can be thought of as deposits along with a default swap that the investor sells to the deposit taker.
The default contingency can be based on a variety of underlying assets, including a specific corporate loan or security, a portfolio of loans or securities or sovereign debt instruments, or even a portfolio of contracts which give rise to credit exposure. If necessary, the structure can include an interest rate or foreign exchange swap to create cash flows required by investor.
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In effect, the investor is selling protection on the reference obligation and earning a premium in the form of a yield spread over plain deposits this is akin to the investor investing money or buying a bond issued by the Reference Entity to earn higher yield than plain deposits. If a credit event occurs during the tenure of the CLD, the deposit accelerates and the investor would get the Deliverable Obligation instead of the Deposit Amount.
On periodic interim dates, Protection Buyer pays to Protection Seller pre-agreed coupon on notional amount; and. If a Credit Event occurs and if cash settlement applies, the transaction shall accelerate and Protection Seller shall pay to Protection Buyer the prevailing market value of the Deliverable Obligations upon occurrence of the Credit Event. Notes can be structured as Medium Term Notes or trust certificates - This shall be subject to regulatory guidelines, if any. Amount of principal redemption is linked to the recovery value of the Reference Obligations.
In the event of default, principal redemption may be cash or physical delivery of the Reference Obligations. Uses and Benefits of CLDs.