Derivations® Demystifying Risk Management Solutions

DERIVATIONS® DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

VOLUME NO. 18

NEW TECHNIQUES IN THE CHALLENGE MANAGING CREDIT RISK

Corporate use of derivatives has broadened Credit derivatives are fast becoming a mainstream tool for investors and financial far beyond currencies and interest rates. managers coping with a variety of credit issues. Credit derivatives represent the next This issue of Derivations offers insights into wave in the evolution of risk intermediation tools taking place in the financial services the growing market for credit derivatives, business. Like predecessor instruments that revolutionized the management of interest the latest tool for disaggregating financial rate, currency, commodity, and equity risk, credit derivatives are fundamentally changing the way credit risk is priced, originated, traded and managed. market risk.

Credit derivatives are the latest vehicle for disaggregating risk. Interest rate derivatives allow hedgers or investors to adjust the interest rate character of a financial instrument without affecting the underlying asset. Similarly, credit derivatives enable financial managers to adjust the credit risk of a financial asset, or portfolio of financial assets, without buying or selling the assets themselves.

Formally, credit derivatives are executory contracts designed to isolate and transfer various aspects of credit risk between parties to the contract. Their payoffs are typically derived from loan or bond values. Payoffs can be based on price movements, credit spreads, credit ratings, or default events. Reference assets can be a single asset, or a basket, or index of assets. Like other derivative contracts, credit derivatives can be cash or physically settled.

“DERIVATIONS: DEMYSTIFYING RISK MANAGEMENT SOLUTIONS” is a registered trade-mark of Bank of Montreal, used under licence. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

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Benefits of Credit Derivatives Credit derivatives allow financials managers to "short" credit risk, opening an avenue for protecting against credit deterioration in a specific asset or group of assets. Since the derivative is a private transaction between the hedger or investor, and a dealer or other third party, it preserves the confidentiality of relationships between the various parties. This is a key advantage in an arena where reputations are at stake.

A second benefit is that credit derivatives can improve capital efficiency, facilitating capital relief from regulators, and opening the door to funding arbitrages. Certain investors, notably banks and broker dealers, can reduce capital charges by investing in an asset issued by a highly-rated borrower, that contains a credit derivative linked to a lower-rated borrower (such as a credit-linked note), rather than directly investing in a loan or a bond issued by the lower-rated borrower. Alternatively, adding credit protection to a note or bond issue can improve the security's credit rating, lowering the rate for the issuer and the capital support required for the investor.

Credit derivatives can also be used to facilitate diversification of credit risk in a loan or investment portfolio. This benefits banks seeking to leverage industry expertise; corporate accounts receivable managers holding uncomfortable concentrations of credit risk; and bond fund managers who want to rebalance a portfolio while minimizing transaction costs.

Building Blocks and Applications As with all derivatives, forwards and options form the basic building blocks of credit derivatives. Forward-based products include credit swaps, default swaps and total return swaps. Option-based products include options on credit risk (credit spreads) and options on default risk. Companies use these tools to achieve a variety of objectives including hedging credit risk on receivables, hedging cross-border credit exposures, and synthesizing debt buy-back.

Traditionally, a company seeking to reduce the level of credit exposure to its customers could turn to factoring, buy accounts receivable insurance, or securitize the receivables themselves. Although widely used, factoring and credit insurance are expensive. Securitization works best for large portfolios of homogeneous assets like mortgages and automobile loan receivables; it works less well for single assets and concentrated credit exposures.

Credit default swaps offer a new source of protection for accounts receivable concentrations. Default swaps (in which the hedger, in exchange for a periodic swap payment, receives a specified dollar payment if a default event occurs while the swap is in effect) can protect a company against default by a client to whom it has extended terms. Default swaps on large investment-grade names are readily available from large banks and insurance companies for terms ranging from very short time periods to several years. In general, the more liquid the reference asset, the more cost- effective the credit derivative. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

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Credit Default Swap

X BPs per Annum or Upfront Fee Protection Protection Buyer Seller Payment Contingent on Event of Default of Reference Asset(s)

Investment in Reference Asset

Default hedges are not necessarily limited to widely available and actively traded assets. However, hedging lower-rated illiquid assets with little price transparency creates structuring hurdles that can leave hedgers with an unacceptable level of residual basis risk. Basis risk considerations include:

· the risk that a credit event (default) will affect the hedged item but not the reference asset; and · the risk that the market value of the hedge will differ from the reference asset (based on different recovery values).

Credit protection can also be purchased for various forms of sovereign risk. These products can mitigate the country risk to which exporters and global investors are exposed. However, basis risk can be a major issue in cross-border transactions; hence transactions tend to be limited to parts of the world with identifiable reference assets and transparent public market pricing. Payoffs are usually tied to equity indices or specific bonds.

Credit derivatives are also used in capital structure management. Companies have long done stock buy-backs when they perceive their shares to be undervalued (Derivations 17 looked at synthetic stock buy-backs), and opportunistic debt repurchases when their notes or bonds are trading below par. Synthetic buy-backs can also be done on corporate debt.

Synthetic Bond Repurchase (Total Return Swap)

Change in Market Value from Today to Scheduled Maturity

Bond Bond Coupon BMO Nesbitt Burns Issuer

LIBOR (or alternative index) + Spread Bond Coupon + Return of Principal

Bondholders DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

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A total return swap on a company's bond issue or a forward debt purchase agreement produces the economic equivalent of a bond repurchase. The swap (in which the hedger receives the total coupon plus the change in price on the bond over the swap's life, and pays LIBOR or an alternative rate index plus a spread) locks in a low market valuation of the target security. It is the economic equivalent of extinguishing the debt today and replacing it with alternatively-priced debt. A forward debt purchase agreement, in which a dealer commits a price for the future purchase of the target notes or bonds, also locks in the below par market valuation without changing the company's debt service profile today. Synthetic debt repurchase can be a cost-effective alternative to defeasing an issue or a public tender offer. The transaction takes place quietly on the dealer's book and avoids the publicity and attendant price adjustment triggered by a debt buy-back announcement.

SUMMING UP

Credit derivatives are fundamentally changing the way credit is priced, originated, traded, distributed and managed. For companies, credit derivatives can be an important tool for managing credit risk separately from the finance/investment process. These techniques represent another extension of the derivatives markets as tools for linking and delinking markets and market risks.

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