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

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APPLICATION OF CREDIT DERIVATIVESYou may ask why Bank A wants to enter into these credit derivativesarrangements such as total return swap. It can simply invest in the interbankmarket or other markets to obtain the same return of LIBOR plus zbasis points which Bank B would pay.This analysis may be correct from a pure yield or return point of view Butbanks have other things to consider. Bank A is concerned that Company X'scredit standing may deteriorate in the long run, but it still wants to keep agood relationship with Company X. Therefore, it continues to supply CompanyX's financing needs. Credit derivatives allow Bank A to continue to have agood relationship with Company X without taking on the credit risk it doesnot want to take. (Bank A does not have to tell Company X that it haspurchased a credit default option or sold a credit linked note relating toCompany X.)Another common application of credit derivatives is to reduce creditconcentration on certain counterparties. For example, Bank A may wantto reduce its exposure to Company X for certain loans or lines of creditwhich have already been on BankA's book by entering into a credit derivativecontract with a third partyOne important characteristic of credit derivatives is that Bank A, theprotection seeker in the above examples, does not necessarily have to holdthe bond of Company X (the reference asset) in order for it to participatein these arrangements. In fact, Bank A does not even have to have anyrelationship with Company X. Bank A simply speculates that an adversecredit event will occur to Company X and trades credit derivatives usingthe bond of Company X as a reference asset. Credit derivatives representa new class of investment for professional investors.REGULATORY IMPLICATIONRegulators need to ensure that banks have proper risk management toolswhich include expertise, systems and controls in place for their creditCredit Derivatives
derivatives operations. Similar to other financial derivatives, banks need tomanage related market risk, credit risk, liquidity risk, operational risk, legalrisk and regulatory risk of credit derivatives.On the other hand, credit derivatives bring up a new topic for regulatorsrelating to the capital adequacy requirement regime. For credit default swaps,the protection seeker to a large extent reduces the original credit exposure.However, in the process, it acquires a new counterparty risk - the creditrisk of the protection provider. How this improved credit exposure situationshould be treated in terms of capital adequacy ratio (CAR) is a sensitive issuefor regulators. For credit linked notes and total return swaps, banks get ridof some of the original credit risk but also acquire new price risk andcounterparty risk. These are also CAR-related issues regulators have to dealwith.POTENTIAL IMPACT OF CREDIT DERIVATIVES TO THE BANKING INDUSTRYTo banks, credit derivatives are not just another financial innovation. Theymay alter the traditional way banks and financial institutions conduct theirbanking businesses. As we all know, at least two thirds (some even say 90percent) of risks in banking activities relate to credit, and credit risk isextremely difficult to quantify and manage. Credit derivatives provide bankerswith a genuine tool to deal with credit issues. For example, a bank canreduce its property exposure using credit derivatives if management thinksthat the property exposure of the bank is too high.Credit derivatives are in a way like mortgage banking business in the USwhere mortgage originators package pools of mortgage loans, unbundle theminto pieces, and sell them to different types of investors in the secondarymarket. Mortgage originators collect the origination fees, keep the servicingright of these loans and earn a servicing spread. Similarly, credit derivativesunbundle the credit risk from a financial instrument. They give banks moreoptions to diversify their portfolios, alter their asset/liability managementstrategies, maneuver their regulatory capital structures, etc. The mortgagebanking business was an innovation in the 80s and later became an industryCredit DerivativesKSm
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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
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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 94 and 95: CREDIT DEFAULT SWAPThe simplest for
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
Page 114 and 115: and the June 3-month futures rate i
Page 116 and 117: needs to take the necessary busines
Page 118 and 119: ief, the policies and procedures sh
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
Page 130 and 131: 20. Where the institution considers
Page 132 and 133: RISK MEASUREMENT25. Having identifi
Page 134 and 135: ) the tendency of the relevant mark
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
Page 142 and 143: 55. As noted earlier, the market or
Page 144 and 145: 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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