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Category: Risk Management in Banking

Tailoring and customizing exposures is a major function of credit derivatives. This helps to reshape individual and portfolio credit risk profiles so that they meet eligibility criteria, for both lenders and investors.

Credit Exposures

Credit derivatives serve as insurance for banking loans. A bank entering into a total return swap will pay the total return of the asset to the protection seller, and receive periodic fixed revenues. This shifts the asset exposure to the counterparty. The same occurs if the bank enters into a default option.

This does not eliminate fully the asset credit risk. For credit risk to materialize, there needs to be a joint adverse credit event (downgrade or default) of the original obligor and the seller of protection. The joint risk depends on correlation of credit events of obligor and seller of protection, and is low as long as credit events do not perfectly correlate. Mismatch between asset value and notional of the derivatives allows further customization of exposures.

The economics of such transactions should consider both the risk and the revenue effect of such hedges. Credit derivatives imply measuring the risk contribution saved by shifting the risk from the original obligor to the protection provider. Depending on the cost of the protection and the gain in risk contribution, the transaction might improve or deteriorate the risk-return profile. Revenues are in values. The value of the risk saving is the required rate on capital times the capital saved. If we can consider that the exposure benefiting from a protection has a near zero risk, as long as the obligor and the protection seller are nearly independent, the risk gain amounts to setting the protected exposure to zero. The full economic analysis necessitates measuring the risk contributions with a portfolio model.

Term Structures

Derivatives help to customize the term structure of credit risk, independent of the maturities of the underlying assets, bonds or loans. Credit derivatives allow a better utilization of the current credit capacity, even though there are no cash deals meeting eligibility and maturity criteria.

Lets assume that a bank or an investor has the ability to take forward exposures, while current commitments use up credit lines entirely. A forward start derivative allows a better usage, as of today, of credit lines. As an example, consider the situation where current commitments are for 2 years, credit lines are available for a longer period and there is no usage between the 2-year commitment and the longer maturity of the lines. Instead of waiting for credit lines to be free in 2 years, it is possible to gain exposure as of today 2 years from now, thereby fully utilizing the current credit lines up to their maturity.

When credit lines are relatively short, there might not exist any attractive cash transaction with such short maturity. However, a financial institution could get exposure for 1 year using eligible reference assets, even though they have a longer maturity. This creates in effect a synthetic short exposure through a credit derivative, terminating in 1 year, and meeting any eligibility criteria, even though there is no cash asset meeting both eligibility and maturity constraints.

Customizing Credit Quality

Credit derivatives allow us to engineer the credit risk quality and spreads using baskets. First-to-default baskets have a credit standing lower than any one of the standalone assets in the basket. Therefore, it is possible to engineer any credit standing independent of what exists in the market by customizing the basket so that it has the desired credit standing. This is like creating a portfolio, but with fewer constraints since we build up the rating in constructing the basket.

The reverse holds as well. With assets held in a portfolio, it is feasible to construct a basket meeting investors requirements exactly. It is easy to proxy the target default probability of a basket as the first-to-default probability. Note that securitizations provide a similar function, since the Special Purpose Vehicle (SPV) issues notes of various levels of seniority, allowing investors to fund the securitized portfolio with tailored default probability.

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