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Credit Derivatives in Managing Off Balance Sheet Risks by Banks

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Credit Derivatives in Managing Off Balance Sheet Risks by Banks City University Business School MSc in Finance 2001 Credit Derivatives in Managing Off Balance Sheet Risks by Banks Submitted by Murat Cakir Supervisor: Giorgio S. Questa This project is submitted as part of the requirements for the award of the MSc in Finance. July 2001 ABSTRACT Credit risk has been a worrying type of risk for financial managers. Fortunately, a recent market development –credit derivatives- has made the credit risk more manageable. The loan portfolio management has become more practicable than it used to be in the past. However, credit derivatives are still not well examined. There are uncertainties about and difficulties in the pricing and portfolio management of credit derivatives due to the non-normality in probability distribution of credit risk. Various models have been developed for credit derivatives pricing. After having drawn the general picture for the credit derivatives, we have studied some recent pricing models in a Das (1999) framework, in this study. Also appended is a an attempt to a step forward for simulating the risk-free rates and spreads, to test how powerful simulation can be in modeling the credit risk and pricing of it. Moreover, with highly developed computer technology, it is possible to make sensitivity analysis under several scenarios, to form imaginary loan portfolios, find their risk exposures, and perform a successful risk management practice. COPYRIGHT MURAT ÇAKIR Central Bank of the Republic of Turkey. All rights reserved. No part of this work 2 may be reproduced, stored in a retrieval system, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except formal use of reference to the author without the written permission thereof Acknowledgements I am deeply grateful to my supervisor Mr. Georgio Questa for all his help, to Messieurs James Riby and Alper Yasar for their assistance in the editing during many sleepless nights, to my family for their unlimited patience for such an unusual child as me. I also would like to thank Mr. Yüksel Görmez for being a difficult and “entertaining” elder brother, and Mr. Yahya Farouqui for supporting me at all times while we were in London. Dedication This “half-finished” work is dedicated to my spiritiual father the Grand Master. Be his help with me forever! COPYRIGHT MURAT ÇAKIR Central Bank of the Republic of Turkey. All rights reserved. No part of this work 3 may be reproduced, stored in a retrieval system, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except formal use of reference to the author without the written permission thereof TABLE OF CONTENTS I. INTRODUCTION ............................................................................................... 6 II. CREDIT DERIVATIVES IN GENERAL.......................................................... 7 II.1. Definition of Credit Risk ................................................................................. 7 II.2. Definition of Credit Derivatives ...................................................................... 8 II.3. Users of Credit Derivatives............................................................................ 11 II.4. Uses of Credit Derivatives............................................................................. 12 II.4.1. Management of Credit Risk........................................................................ 12 II.4.2. Optimization of Balance Sheet Use............................................................ 14 II.4.3. Tailoring Investments ................................................................................. 15 II.4.4. Exploiting Relative Value........................................................................... 16 II.5. Types of Credit Derivatives........................................................................... 17 II. 5.1.Total Return Swaps (TRSs)........................................................................ 17 II. 5.2. Credit Default Swaps (CDSs).................................................................... 19 II. 5.3. Credit Spread Options (CSOs)................................................................... 20 II. 5.4. Credit Forwards (CFs) ............................................................................... 22 II. 5.5. Credit-Linked Notes (CLNs) ..................................................................... 22 II.6. Credit Derivatives in Practice........................................................................ 25 II.6.1. Loan Portfolio Management ....................................................................... 25 II.6.2. Mergers and Acquisitions Transactions...................................................... 26 II.7.Pricing and Hedging Considerations .............................................................. 27 II.7.1. Pricing Issues .............................................................................................. 27 II.7.2. Hedging Issues............................................................................................ 30 COPYRIGHT MURAT ÇAKIR Central Bank of the Republic of Turkey. All rights reserved. No part of this work 4 may be reproduced, stored in a retrieval system, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except formal use of reference to the author without the written permission thereof III. PRICING CREDIT DERIVATIVES .............................................................. 31 III.1. Technicalities in Pricing Credit Derivatives ................................................ 33 III.1.1 Spread Models............................................................................................ 33 III.1.1.1. One-Factor Spread Model ...................................................................... 35 III.1.1.2.Two-Factor Model................................................................................... 37 III.2. Modeling the Spread in Detail...................................................................... 42 III.3. The Jarrow-Lando-Turnbull (JLT) Model ................................................... 44 III.4. The Das-Tufano (DT) Model ....................................................................... 50 III.5. The Duffie-Singleton (DS) Model ............................................................... 59 III.6. Other Issues Concerning the Credit Risk Models ........................................ 61 IV. CONCLUSION ............................................................................................... 64 BIBLIOGRAPHY ................................................................................................. 65 APPENDICES....................................................................................................... 69 APPENDIX A ....................................................................................................... 70 APPENDIX B........................................................................................................ 79 LIST OF FIGURES FIGURE 1. TRIGGERING EVENTS AND CREDIT DERIVATIVES .............. 10 FIGURE 2. TOTAL RETURN SWAP CASH FLOWS ....................................... 18 FIGURE 3. CREDIT DEFAULT SWAP CASH FLOWS.................................... 19 FIGURE 4. CREDIT SPREAD PUT .................................................................... 21 FIGURE 5. CSO CASH FLOWS IN EXERCISE ................................................ 21 FIGURE 6. THE STRUCTURE OF A CREDIT DEFAULT NOTE ................... 24 FIGURE 7. TRS LOAN PORTFOLIO CASH FLOWS....................................... 26 COPYRIGHT MURAT ÇAKIR Central Bank of the Republic of Turkey. All rights reserved. No part of this work 5 may be reproduced, stored in a retrieval system, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except formal use of reference to the author without the written permission thereof I. INTRODUCTION Banks and other non-bank financial institutions are today’s most complicated economic units. Their overall portfolios are more so... The management of these portfolios is one of the greatest challenges facing the financial manager. With the introduction of credit derivatives and mechanisms that allow institutions to un- bundle the credit risk (CR) portion of traditional debt instruments from market risk (in an effort to improve pricing efficiency), this challenge could have been better and more easily handled in the last decade. The goal of a portfolio manager—regardless of whether the portfolio is composed of equities or credit assets—should be to create an “efficient” portfolio. With equities, the manager can usually buy and sell assets until he attains the optimal level of diversification. However, the manager of a loan portfolio typically faces several constraints and conflicting objectives while managing this portfolio. For example, some of the loans in the portfolio may be liquid, and those that are may not be truly saleable because of restrictions in the documentation or the effect of a sale on the relationship with the borrower(s). Credit derivatives (CDs) provide loan portfolio managers with a number of ways of constructing and shaping a portfolio and managing the conflicting objectives they have to face on both micro and macro levels. Firstly, CDs can be used to reduce the portfolio’s exposure to specific borrowers (obligors) or to diversify the portfolio by synthetically
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