Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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CREDIT DEFAULT SWAPThe simplest form of credit derivatives is credit default swap (or defaultoption) in which Bank A (the protection seeker) pays a fee (usually in basispoints) to Bank B (the protection provider) to protect the financial lossarising from the default or other credit event of the Company X bond (thereference asset). Bank B is usually a much stronger company than CompanyX, otherwise it makes no sense for Bank A to seek protection from Bank B.Bank A(Protection Seeker)Company XBondFee in bps per quarterNotional of the contract lessrecovery value of Company Xbond if credit event occurs/zero if no credit eventBank B(Protection Provider)Under the terms of the contract, if a defined credit event or default occursduring the term of the contract, Bank B will pay Bank A the notional of thecontract less any recovery value of the reference asset (usually 90 days afterthe defined event).This arrangement is like an insurance policy, a guarantee or a letter ofcredit But the key point is that the credit risk of this bond has been"unbundled" away from the bond. For example, under the credit defaultoption contract, Bank A pays Bank B 12 basis points on a $10 millionnotional per quarter for five years. If a credit event occurs during theperiod, and the market price of the reference asset is 75 three monthsafter the event, Bank A will get $2.5 million (the face value of $10 millionminus the recovery value of $7.5 million) from Bank B.CREDIT LINKED NOTEBank A can also sell something called "credit linked note" to protect theloss arising from the default or credit event of the Company X bond. Inthe arrangement of a credit linked note, Bank A issues a note linked to thesubject bond (the reference asset), and the note pays a specified fixed orCredit Derivatives
floating interest rate just like other notes. Bank B buys the note at par. Ifno default or defined credit event occurs during the term of the note, thenote will mature at par. However, if a defined credit event occurs, the notewill be redeemed for the recovery value of the reference asset (usually 90days after the credit event). For example, Bank B purchased a $10 millioncredit linked note from Bank A and Company X's credit rating declined fromBBB to BB during the term of the note and this rating decline is defined asa credit event. The subject bond's market value is 65 three months afterthe rating decline. The note will be redeemed for the recovery value of$6.5 million. Therefore, Bank A's gain of $3.5 million from the credit linkednote transaction will offset the loss of $3.5 million due to its holding of a$10 million Company X bond.Bank A(Protection Seeker)iCompany XBondPrincipal of noteInterest on noteRecovery value if credit eventoccurs / principal at maturityif no credit eventBank B(Protection Provider)TOTAL RETURN SWAPIn a total return swap arrangement, Bank A (the protection seeker) agreesto pay Bank B (the protection provider) all contractual payments plus anyappreciation in market value of the subject bond (the total return on thereference asset), and Bank B agrees to pay Bank A LIBOR plus specifiedbasis points, say z bps, as well as any depreciation in market value of thereference asset during the term of the swap.Bank A(Protection Seeker)Company XBondTotal return onCompany X bond(all contractual payment+ appreciation)LIBOR + z bps + depreciationBank B(Protection Provider)Credit Derivatives
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THE UNIVERSITY OF HONG KONGLIBRARIE
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VI- . .7 « i8^p ! ««^^OOSHSlVCJ
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Ever since derivatives took centre-
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denominator, value at risk, which c
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the kind of information that superv
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This book is a team effort of the H
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While most market participants defi
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of this investment is 6.32 percent
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Mathematically, the relation betwee
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$10,000. (For simplification of pre
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Hong Kong does go up and the HSI ri
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3OF ATHEPRICING OF A FORWARD CONTRA
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COST OF CARRYIn the above example,
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interest rate swap rates. From thes
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Borrowers, on the other hand, usual
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Again we use our method of having t
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ates, the forward rate for the peri
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5In this chapter, we will discuss w
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often complain that there is too mu
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ABC also has three cash flows:1. It
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Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79: OF AN11In the previous two chapters
Page 80 and 81: at-the-money option approaches its
Page 82 and 83: 12Mortgage-backed securities (MBS)
Page 84 and 85: NEGATIVE CONVEXITYFor MBS, there is
Page 86 and 87: MULTI-CLASSIn 1983, Freddie Mac int
Page 88 and 89: 13What is a hedge? According to the
Page 90 and 91: management to enter into swap and o
Page 92 and 93: transaction. For this criterion to
Page 96 and 97: APPLICATION OF CREDIT DERIVATIVESYo
Page 98 and 99: in the US. Equally innovative, cred
Page 100 and 101: THE VARIANCE-COVARIANCE METHODThe t
Page 102 and 103: "cell" would have a cash flow expos
Page 104 and 105: Daily profit and loss ranked in asc
Page 106 and 107: of the market factor. Through this
Page 108 and 109: 3. Most value at risk models use hi
Page 110 and 111: 16ANDIn Chapter 5, we talked about
Page 112 and 113: price) of 9,000. For this transacti
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Page 116 and 117: needs to take the necessary busines
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Page 120 and 121: The derivatives industry can be com
Page 122 and 123: ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
Page 126 and 127: ensure that there is sufficient awa
Page 128 and 129: 15. Branches of foreign banks which
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Page 132 and 133: RISK MEASUREMENT25. Having identifi
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Page 136 and 137: 38. The measurement of the market r
Page 138 and 139: market, credit and liquidity risk o
Page 140 and 141: Consideration must be given to the
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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