Technische Universität München Credit as an Asset Class - risklab

CHAPTER 2. CREDIT RISK TRANSFER
Within the recent years, a shift in credit quality of the reference entities has taken
place. While in 2002 the share of AAA-rated reference entities was 22%, it decreased to
14% in 2004. A similar reduction on a relative basis can be observed for AA- and A-rated
reference entities. In contrast, the share of BBB-rated reference entities increased from
28% in 2002 to 32% in 2004. The share of below investment-grade rated reference entities
increased from 8% in 2002 to 24% in 2004. These developments have various reasons:
Partly, the shift in the high-rated reference entities can be explained by a negative ratings
migration. But there is also a change in investors’ needs and in the structure of the market
participants. There is a growing demand for high-yield CDS indices and index products,
which is driven to a large extent by hedge funds. They are looking for an alternative way
to trade credit risk, with a focussed interest in high-yield assets. 60
Standardisation of Documentation
Credit derivatives are legally binding contracts between two counterparties, which may
involve legal risk 61 and enormous transaction costs (including setup, negotiation and ad-
ministration costs), if every contract is negotiated individually. The counterparties have
to agree upon key items, such as maturity, premium, reference entity, credit event, etc.. 62
In order to standardise the contracts and to facilitate trading, the International Swaps
and Derivatives Association (ISDA) 63 has pursued a steady convergence of documentation
standards for basic credit derivatives contracts. In 1997, ISDA published the first set of
credit derivatives documents. In 1999, the association issued the ”Master Agreement”
and the ”Credit Derivatives Definitions”, of which a new version was published in 2003.
The former is a contract of general nature between the two counterparties on which is
agreed upon before the first credit derivative contract is signed. It contains legal aspects,
procedures in case of default of one counterparty, etc.. The latter defines key terms, such
as possible credit events or possible settlement procedures. ISDA in cooperation with
its members has continuously improved these publications in order to meet the changing
needs of market participants. 64
The ISDA standard contract specifies all obligations and rights of the counterparties
as well as key definitions, such as reference entity, credit event and its verification, etc. It
contains some fixed core terms and definitions, some clauses, however, are variable.
Several events can be included in the definition of a credit event, for example bank-
ruptcy, obligation acceleration, failure to pay, moratorium, restructuring. 65
Credit derivatives can be settled either physically or cash. Physical settlement means
that in case of default, the protection buyer has to deliver the designated obligation to the
protection seller in return for the par value of the reference obligation. Cash settlement
means that if a credit event occurs, the protection seller has to pay the difference between
the par value and the market value or the recovery value of the reference obligation to the
protection buyer in cash.
60
See [Fit05], p. 7, 10.
61
The legal risk involved in credit derivatives contracts is described in Section 2.3.4.
62
See [Bom05], p. 26, [Cha05], p. 57.
63
ISDA is an association composed of leading swap and derivatives market participants.
64
See [Bom05], p. 26, 286, [BR04], p. 17.
65
For a description of the events, we refer for example to [Das06], pp. 712-717 or to [Bom05], pp.
289-290.
23