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Category: Risk Management in Banking

Hedging is the most direct application of credit derivatives for bankers looking to insure against excessive risks or aiming to reshape the risk of their portfolios.

Contributions of Credit Derivatives

Simple transactions cannot disentangle the various risk components embedded in them. We can try to hedge the credit risk of a bond by selling short another similar bond. However, this transaction does not eliminate the specific risk component. If interest rates move, the changes of prices offset if durations match. However, the issue is to neutralize the long credit risk by going short in a similar credit risk for hedging. Using identical rating bonds would not help either, because the credit spreads do not correlate in general. It is possible that both bond spreads will increase by the same magnitude, but there is no mechanism that guarantees this. It would only happen with similar issues from a common issuer. The general credit risk of both assets might offset, but the specific risks will not. All specific risks of all obligors are independent by definition, if measured properly. The implication is that adding an exposure, even if this exposure shorts another exposure in the portfolio, cannot neutralize the risk. There is always an incremental specific risk. If we add many exposures in a largely diversified portfolio, the incremental risk of each additional exposure is always positive. It becomes a smaller fraction of the total risk, but it is never negative. Hence, there is no way to hedge the specific ingredients of credit risk using simple transactions.

Hedging Defaults or Downgrades

Credit default swaps or total return swaps provide hedges against defaults or downgrades. Moreover, credit spread swaps isolate the spread component. This is of direct interest to protection seekers. It also provides additional flexibility to manage portfolios, because transferring the risk helps in developing new transactions. Protections against rating downgrades also provide the possibility to control or get rid of exposures contingent on ratings.

Without such protections, it might be impossible to hold assets subject to a minimum rating constraint. Credit derivatives guarantee that the minimum target rating holds through the horizon of the reference assets. Derivatives formatted as puts to sell the asset at an agreed price terminate the transaction if there is a downgrade. A standard put does not perform the same function since it does not differentiate the effects of credit deterioration and of a change in market rates. These options on spreads work like covenants triggering default if the credit standing deteriorates beyond some threshold. However, covenants necessitate interactions with the lender, with smaller chances of success if the lender cannot do much. Then the loan repayment will simply accelerate and the loss materialize. On the other hand, a spread option will work.

Hedging Sovereign Risk

Exposure to sovereign risk is very common for financial and non-financial organizations. As mentioned previously, country risk is a bundle of political risk, economic risk, default risk related to local economic conditions and convertibility risk. Ignoring the default risk of private obligors, we concentrate on pure sovereign risk. Credit derivatives serve in various ways to provide some, but less than perfect, protections.

A default or downgrade derivative on any sovereign issue provides some protection. However, if the risk materializes without any default or downgrade, the hedge is not effective. Alternative hedges use the prices of the sovereign issues. Risk widens spreads and lowers prices. A spread derivative might be a more attractive protection than a downgrade protection. However, spreads are often related to liquidity, so that a liquidity crunch in an emerging market, unrelated to the credit standing of the sovereign, might not be effective because it will trigger the derivative even if there is real underlying economic risk.

Hedging Syndication Risk

Syndication is the classical process of raising funds with a bank, the underwriter, later sold to other banks for purposes of diversification. The final take is the fraction of the funding retained by the underwriter. Syndication implies several risks: keeping a larger amount of the funds for a longer than expected time; selling a fraction to other banks at a lower than predicted spread, if not agreed in advance. During the process, the bank has a large exposure and is subject to spread risk.

This makes it useful to customize the size of the intermediate exposure, the term of the exposure and the spread. Customization of all three items for the expected horizon of syndication, from inception up to final take, avoids excess exposures. Over-exposure beyond expected volume and horizon freezes other business opportunities because it makes credit lines unavailable. The cost of such excess exposure is both direct, in terms of risk borne by the underwriter, and indirect, in terms of missed opportunities. The economics of the hedging transaction need a careful calculation of all revenues, hedging costs and risks.

Hedging Uncertain Exposures of Derivatives

Credit derivatives can help insure uncertain potential excess exposures arising from the current derivative portfolio. The bank holding these derivatives fears an increase in exposure due to market parameter changes, leading to unacceptable exposures. Instead of insuring the potential excess exposure, the bank enters into a credit default swap on variable exposure. The default payment will be proportional to the variable exposure of the derivatives. The payment can be either the prevailing mark-to-market of the swap, or its excess above a threshold, or the exposure up to a certain amount, minus an agreed recovery rate. Such a credit default swap linked to the swap mark-to-market value differs from a standard swap since exposure is uncertain at inception of the deal.

If there is no excess exposure, there is no payment in the event of the counterparty defaulting on the derivatives held by the first bank. The economics of the transaction depend on the cost versus an insurance against excess exposure, the likelihood of hitting a higher level of exposure. With market-driven exposures, credit risk interacts with market risk so that both expectations on credit risk and market risk play a role in the feasibility of the transaction.

Hedging and Restructuring a Loan

Sometimes loans need restructuring at origination because they do not fit the banks constraints. Instead of restructuring the transaction with the client, the bank can restructure the transaction with credit derivatives to meet the constraints. Such restructuring means customizing the exposure, the revenues, the spread risk, and the maturity of the commitment with credit derivatives. For instance a forward loan swap, starting 2 years from now, effectively restructures the exposure to this horizon whatever the actual maturity of the loan contracted. Both the total return swap and the credit default derivative serve for such purposes.

Hedging for Corporates

Corporations usage of credit derivatives is straightforward. Sometimes, firms face country risk to a significant extent. The customers portfolio of receivables of a corporation has credit risk exposure, making hedging attractive. Dependency on a few major customers, who have significant default risk, is an additional incentive to enter into such transactions. Another important application for corporate entities is protection against the widening of credit spreads, because they influence directly the cost of borrowing, a significant cost item in the income statement of a leveraged company. Just as a forward derivative locks in interest rates for the future, credit spread forwards achieve the same result for this component of the cost of debt.

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