Once Upon A Time…

The fairy tale of credit derivatives

Mirko Filippi, Bloomberg L.P.
Originally published in the July/August 2006 issue

The inception of the credit derivatives market has dramatically changed the transfer of credit risk and the “fairy-tale” pace of its growth and increasing complexity are unquestionably unmatched. Who could have forecast 10 years ago that a market — virtually non-existent at that time — would have transformed into a booming $17+ trillion self standing asset-class that would now represent almost 7% of the aggregated derivatives market?

How did this financial fairy tale become a reality? In retrospect, it is easily explainable by the increasing awareness in the marketplace of:

  • the need to address the remaining component of business risk (credit) for whichno standardized and efficient tailor-made financial product existed,
  • the advantages credit derivatives possess over the underlying cash bond market, and
  • the new opportunities, risk and payoff profiles offered to both credit investors and hedgers (diversification, yield pickup or new ways to take an exposure and satisfy diverse risk appetites)

The original reason for the existence of credit derivatives was to enable the efficient transfer and repackaging of credit risk; in their basic form, they offer a more efficient way to replicate in a derivative format the credit risks that would otherwise exist in a standard cash instrument.

Also, interest rate derivatives in the 1980s introduced the ability to manage and engineer exposures such as duration, convexity and callability independently for a cash bond portfolio; credit derivatives complete the process by allowing the separation of exposure to default or credit deterioration.

The two main building blocks of the credit derivatives market are Single Name CDS and CDS Indices.

The purchase of a Single Name CDS represents the first standardized mechanism to replicate synthetically the payoff of a short position in a debenture, without being subject to the risk of a short squeeze and without being limited by the scarcity of issuance of debt instruments from a specific reference entity.

A standard CDS is usually priced at par off the “fee leg” spread so that the fee leg and the contingent leg have the same PV. Differently from a plain IRS, its fixed leg PV has stochastic components and is a function of the survival probability and the “deal” recovery rate; its contingent leg is a function of the default probability curve and the curve recovery rates.

Since CDS is ultimately a spread-based product, market makers have opted to price it by quoting CDS curves annually spaced with quarterly frequency and a 40% recovery; default and survival probabilities can be stripped implicitly. Recently some high yield CDS have traded as price based (% of the notional) with a 500 bps running spread.

A major push in the CDS market growth has been the introduction of CDS Indices that roll every six months on new sets of reference entities. Indices are priced similarly to Single Name CDS and most of their liquidity is on-the-run; they have brought over a simpler way to hedge credit portfolios and a standardized basis to construct more complex credit derivatives based on a pool of underlyings.

Furthermore, the CDS market is a stunning example of how to transfer financial engineering achievements from other asset classes. Second order exotic credit derivatives such as synthetic loss tranches and default baskets create new risk-return profiles to appeal to the differing risk appetites of investors based on the tranching of portfolio credit risk.

The flourishing market of bespoke tranches is facilitated by the infinite number of payoffs obtainable by combining diverse individual notionals, recovery rates, tranche sizes, attachment and detachment points and correlation.

Second order CDOs emphasize the control over pools of collateralized securities whilst hybrid CDOs can create exposure to a mix of CDS, EDS, loans, mortgages etc. The result is that credit correlation itself has become the most arcane and argued theoretical concept in quantitative finance today .

On the other side, CDS Swaptions allow investors to express a view on credit spread volatility. They grant the holder the right but not the obligation to enter a forward-start CDS contract to buy or sell protection. The majority are European style and on indices, where the protection provided by the underlying contract has already begun at settlement of the option. The option counterparties most often trade on the on-the-run CDS Index and for this reason options have a very standard no-Knock-Out provision which entails that in case any credit events happen in the underlying portfolio the derivative contract does not cease to provide protection to the holder.

Swaptions give investors the potential of expressing cheaply their views on the most likely forward trading range. Interestingly, CDS Swaptions traders can play two Convexity profiles: the first entails the change in DV01 for the underlying (which is parabolically decreasing with the increase of the CDS curve levels, meaning that the sensitivity of an ITRAXX contract to curve shifts tends to zero for high spread environments), and the second refers to the Swaption itself.

The latest trend in the CDS market is to extend synthetic protection to other debentures such as loans, mortgages or baskets of those. The CDS price is then impacted by additional variables such as prepayment speeds, writedowns/writeups, interest shortfalls and repayments.

The major obstacle for the growth of the credit derivatives market has been represented by the pressure placed on leading financial firms to cope with the paperwork generated by the exponentially increasing number of transactions. Regulators have called on banks to cut the backlog on concern the unsigned trades threaten the stability of the financial system. The documentation backlog has now been addressed.

Bloomberg, which has had a central role in the development of the Credit Derivatives market, is working with its customers to provide tools that are spurring this market along. Bloomberg’s extensive CDS data includes updated credit curves for more than 1300 reference entities with executable, intraday and historical prices. Calculators such as CDSW, CDSM, and CDSO are being used by market participants every day.

The most recent development in this market, the integration of T-Zero and Straight Through Processing on the bloomberg professional service, allows counterparties to use one system to communicate details of trades, get agreement from all parties and then produce an electronic affirmation to all required entities (counterparties, prime brokers and clearing such as DTCC). Adopting T-Zero is the optimal solution for clients who want to achieve trade date affirmation of all their Credit Derivative trades.

It will substantially reduce the cost of processing a trade by dramatically improving the speed at which errors can be identified and resolved. Even more important, it will take away the risks associated with unmatched transactions.