2019 Revision Notes 8 - Chapter 8 6

Financial Intermediation Revision
2 Chapter 6, 8
Credit Derivatives
Risk management with derivative instruments
FINANCIAL INTERMEDIATION
REVISION OF CHAPTER 6 & 8
Lillibeth Ortiz / 2019
FI Revision Classes / Lillibeth Ortiz / 2019
Learning Outcomes (Chapter 8) Learning Outcomes (Chapter 6)

3 4
 outline the key steps in the valuation of swap contracts  Adequately explain key market participants’ motivations
 adequately describe the principle of delta hedging using for engaging in the credit derivatives market
given concepts  Detail the structure and uses of given credit derivatives
 apply the principle of delta hedging in well-defined risk products
management situations with minimum guidance
 illustrate how foreign exchange rate risk can be managed
using forward contracts and money market instruments
 illustrate how interest rate risk can be managed by using
standard swap contracts.
FI Revision Classes / Lillibeth Ortiz / 2019 FI Revision Classes / Lillibeth Ortiz / 2019
Overview: Chapter 8 Overview: Chapter 6

Derivatives Loan sales Pass-through
5 security
Sell assets Asset
Over-the- Exchange Backed Collateralized
mortgage
Securiti-
counter traded Risk zation
obligation
Transfer Mortgage-
backed bond
Forward Futures (increase
contracts • FX flexibility of Total Return
• FX • IR (eg, Eurodollar) operations) Swap
Credit Credit Default

Swaps Call & Put Hedge Risk Products
Options Derivatives (Swap. Option)
• IR
• FX • Share or Index Credit Spread
• Credit Default / Total Return Products
6 (Forward, Call)
Lillibeth Ortiz 1
Overview: Chapter 6
Past Year Exam Questions (Chapter 6 & 8)
Credit Derivatives
7 8
 Using credit derivatives as examples, explain the different

Total return Credit default Credit spread structures of forwards, options and swaps. (2016, 2014 &
swap products products 2012, ZA)
 Explain the structures of credit derivative products and
• Payments are • Payoff based on • Payoff based on
linked to the total specified credit the credit spread discuss the motivations for using such products. (2018 –
return on a events on a specified ZAB, 2015 ZB)
specific asset • E.g., Credit bank loan or  Using appropriate examples, explain how banks use
default swap bond forward and swap contracts to manage credit risk,
(pure credit • E.g., Credit exchange rate risk and interest rate risk. (2018 ZAB, 2015
swap) or Credit forwards or ZA)
default option Credit spread call  Explain the constituents of credit risk and discuss how
option
these risks could be managed or hedged. (2015ZA,2013ZB)
Similar Past Year Exam Questions Examiners’ Commentaries

9 10
 Using appropriate examples, explain how banks use  Introduction: Establish the key features of the main
forward and swap contracts to manage credit risk, derivative instruments which are used to hedge the three
exchange rate risk and interest rate risk. (2015 ZA) categories of risk mentioned in the question.
 Using examples, explain how banks use derivatives to  Compare forwards/futures, options and swaps
manage credit risk, exchange rate risk and interest rate  Main Body
risk. (2013 & 2011, ZA)  Part 1: For managing interest rate risk, swaps would be the
obvious instrument (in this syllabus)
 Part 2: For managing exchange rate risk, focus the analysis
on the covered interest parity condition
 Part 3: For managing credit risk, discuss credit derivatives
Introduction Introduction: Derivatives

(from Futures and Forwards Tutorial Question 1)
11 12
 What are derivative contracts?  Derivatives are financial assets whose value is determined by
the value of some underlying asset. As such, derivative
 What is the value of derivative contracts to the managers contracts are instruments that provide the opportunity to
of FIs? take some action at a later date based on an agreement to do
 What are the key features of the main derivative so at the current time. Although the contracts differ, the
instruments? price, timing, and extent of the later actions are usually
agreed upon at the time the contracts are arranged.
 How do forwards/futures, options and swaps differ? Normally the contracts depend on the activity of some
underlying asset.
 The contracts have value to the managers of FIs because they
aid in managing the various types of risk prevalent in the
institutions.
 The largest category of derivatives in use by commercial
banks is swaps, which was followed by options, and then by
futures and forwards.
Lillibeth Ortiz 2
Overview: Chapter 8
Introduction: Futures and Forwards
Forward Contracts
13 14
 Futures and forward contracts both are agreements Forward A tailored enforceable contract that sets the price of
between a buyer and a seller at time 0 to exchange the Description an asset today for delivery of the asset at a future
asset for cash (or some other type of payment) at a later date, with settlement usually only at maturity
time in the future. Pay-Offs Long position gains when price goes up (above
 A forward contract is an over-the-counter agreement that requires forward price)
delivery or taking delivery of some commodity or security at some Application Foreign Exchange (per learning outcomes)
specified time in the future at some price specified at the time of (Hedging)
origination.
Valuation Forward price: Related to current spot price of the
 A futures contract is a standardized enforceable contract traded on a
asset and all carrying costs: storage cost, insurance
centralized regulated exchange with daily settlement of gains & losses
plus the interest costs less the income earned
 The specific grade and quantity of asset is identified, as is the specific
price and time of transaction. Traded Over the counter
 Hedging with forwards or futures eliminates both upside and
downside
Overview: Chapter 8
Introduction: Options
Futures Contracts
15 16
Futures An agreement involving the future exchange of a  Options give the holder the right but not obligation to
standardized, pre-specified asset for cash at a buy or sell a specific quantity of an underlying asset at a
Description
price that is determined daily; traded on a pre-determined price on or before a specific date
centralized regulated exchange with daily  Examples of underlying assets are stocks, indices,
settlement of gains & losses currencies, interest rates etc.
Pay-Offs Long position gains when price goes up  Call option
Application FX, IR, Commodities  A right but not an obligation to buy a particular quantity of an
(Hedging) underlying asset at a pre-specified exercise or strike price.
Valuation Similar to Forward
 Put option
Traded Exchange
 A right but not an obligation to sell a particular quantity of an
underlying asset at a pre-specified exercise or strike price.
 Hedging with options eliminates risk in one direction only
Overview: Chapter 8
Introduction: Swaps
Options
17 18
Options Right but not obligation to buy (call) / sell (put) a  A swap is an agreement between two parties to
Description specific quantity of an underlying asset at a pre- exchange assets or a series of cash flows for a
determined price on or before a specific date periodic period of time at a specified interval
Pay-Offs Long position gains when price:  Types: Interest rate, Currency, Total Return, Credit, Basis,
• rises above strike price for a call; and Asset, Equity, Commodity, Forward swap
• falls below strike for a put  In a swap, each party promises to deliver and/or receive a
Otherwise, loses only up to upfront option premium pre-specified series of payments at specific intervals over
Application Delta Hedging (per learning outcomes) some specified time horizon. In this way, a swap can be
(Hedging) considered to be the same as a series of forward contracts.
Valuation Various Models (e.g., Binomial or Black-Scholes)
Traded Exchange (mostly) & Over the counter
Lillibeth Ortiz 3
Overview: Chapter 8 Main Body Part 1: Hedging Interest Rate

Swaps (IR) Risk (from Examiners’ Commentaries)
19 20
Swaps A swap is an agreement between two parties to  Part 1: For managing interest rate risk, swaps would be
Description exchange assets or a series of cash flows for a periodic the obvious instrument (in this syllabus)
period of time at a specified interval
 Explain the source of interest rate risk faced by the parties
Pay-Offs As specified by swap
involved
Popular Use Interest Rate Risk, Credit Risk (per learning outcomes)  Highlight basis for swaps: comparative advantage in
for Hedging borrowing at fixed and floating interest rates.
Valuation Replicating portfolio:
 May extend to currency swaps
•Present value of the sum of a number of forward prices
•OR, an Interest Rate Swap to the fixed rate payer is a
combination of:
•Issuing a fixed rate bond (pay fixed)
•Buying a floating rate note (receive floating)
Traded Over the counter (moving to an exchange)
First Then
Main Body Part 1: Interest Rate Risk describe
the risk
Main Body Part 1: Interest Rate Swaps describe how
to hedge it
21 22
 Any significant change in interest rates can affect the  Interest Rate Swap
profitability of the bank  An agreement between two parties to exchange a series of
 Interest rate risk resulting from intermediation: cash flows based on a specified notional principal amount
 Mismatch in maturities of assets and liabilities.  Two parties facing different types of interest rate risk can
 When assets are longer term than liabilities, Refinancing risk –the exchange interest payments of different natures:
cost of rolling over or reborrowing funds may rise above the returns  A floating rate against a fixed rate
being earned on asset investments  A fixed rate against a floating rate
 When assets are shorter term than liabilities, Reinvestment risk – the  A specific floating rate against another floating rate
returns on funds to be reinvested may fall below the cost of funds
 At each payment date, in a plain vanilla IR swap
 Balance sheet hedge via matching maturities of assets and
liabilities is problematic for Fis. Swap Buyer Fixed rate Swap Seller
(long) (short)
Floating
Source: Saunders & Cornett,
FIK.R. Stanton
Revision Classes / Lillibeth Ortiz / 2019 FI Revision Classes / Lillibeth Ortiz / 2019
Main Body Part 1: Interest Rate Swap

Main Body Part 1: Interest Rate Swaps
Example (from Swaps Tutorial Question)
23 24
 Purpose of interest rate swap  Comparative Advantage

Example Fixed rate
 Allows FIs to economically convert variable-rate instruments 11%
into fixed-rate (or vice versa) in order to better match the  Bank 1 can issue five-year Bank 1 CDs
CDs at an annual rate of 11
duration of assets and liabilities. percent fixed or at a variable
 Often used to take advantage of arbitrage opportunities rate of LIBOR plus 2 percent. LIBOR
resulting from capital-market inefficiencies.  Bank 2 can issue five-year +2.5%
 Arbitrage opportunities exist whenever comparative advantage exist. CDs at an annual rate of 13
12%
percent fixed or at a variable
rate of LIBOR plus 3 percent.
LIBOR
 A mutually beneficial swap +3%
between the two banks is Bank 2 CDs
possible. For example:
FI Revision Classes / Lillibeth Ortiz / 2019 Source: Saunders & Cornett, K.R. Stanton FI Revision Classes / Lillibeth Ortiz / 2019
Lillibeth Ortiz 4
First
Main Body Part 2: Hedging Foreign Exchange
(FX) Risk (from Examiners’ Commentaries)
Main Body Part 2: Foreign Exchange Risk
describe
the risk
25 26
 Part 2: For managing exchange rate risk, focus the  Risk that exchange rate changes can affect the value of a
analysis on the covered interest parity condition. bank’s assets and liabilities denominated in non-domestic
 Demonstrate the mechanics of a forward hedge and of a currencies
money market hedge & how, if the parity condition holds,  Mismatches between foreign asset and liability portfolios
the two hedging techniques produce the same outcome.  Returns are affected by:
 Ideally, demonstrate by numerical examples.
 Spread between costs and revenues
 Changes in FX rates
Then
Main Body Part 2: Hedging FX Risk using
Main Body Part 2: Hedging FX Risk describe how
to hedge it Forward or Futures contracts
27 28
 Two common techniques for hedging foreign exchange  Match the asset (liability) position with an offsetting
risk: forward contract of equal value & maturity
 Using forward contracts (& futures)  Bilateral contract between user & a bank
 Using the money markets
 Expect to receive foreign currency -> sell the foreign
 Other examples: currency forward
 Currency swaps
 Expect to pay out foreign currency in the future -> buy
 Options
the foreign currency in the forward market
Main Body Part 2: Hedging FX Risk using Forward

Main Body Part 2: Covered interest rate
contracts: Examples
(from Futures and Forwards: Tutorial Question) parity
29 30
 A U.S. bank lends to a Japanese company; the loan is  Equilibrium condition is that there should be no arbitrage
payable in Yen. opportunities available through lending and borrowing
 The bank should sell Yen forward to protect against a across currencies.
decrease in the value of the Yen, or an increase in the value  The forward exchange rate differs from the spot exchange
of the dollar. rate by a factor which is determined by the interest rate
 An FI has borrowed in Euros. differential between respective countries. Thus, the price
 The FI should buy € forward of a currency forward under continuous compounding is
F = Se(r-rf)(T-t)
where:
 r is the domestic interest rate
 rf is the foreign interest rate
 S is the spot exchange rate in LCY terms
Can use specific
 T-t is the time period
amounts as examples
Lillibeth Ortiz 5
Main Body Part 2: Hedging FX Risk using

Main Body Part 2: Hedging FX Risk
the Money Market Hedge
31 32
 Alternative: money market hedge

 Offset the FCY to be received/paid by borrowing or lending Receive FCY Pay FCY
in the foreign & domestic money markets (Long) (Short)
 Goal is to lock-in the LCY amount equivalent to be
received/paid in the future
 Covered interest parity condition ensures that the
Sell FCY in Borrow FCY, Buy FCY in Borrow LCY,
amount received in money market and the amount
forward or Convert to forward or Convert to
received in forward hedge are almost equal
futures LCY @ Spot, futures FCY @ Spot,
 Money market hedge = synthetic forward contract market Invest LCY market Invest FCY
Main Body Part 2: Hedging FX Risk using Main Body Part 3: Hedging Credit Risk
Currency Swaps (from Examiners’ Commentaries)
33 34
 An agreement between 2 parties to exchange cash flows  Part 3: For managing credit risk, discuss credit derivatives:
in one currency for cash flows in another currency  Credit default swaps, credit forwards and credit spread
 The principal sums will be exchanged unlike an interest options
rate swap & the principal sums will be re-exchanged at  Provide examples and payoff diagrams
the end of the tenure
First Then
Main Body Part 3: Credit Derivatives describe
Main Body Part 3: Credit Risk describe how
the risk Overview to hedge it
35 36
 The risk that counterparty to a financial transaction will  Credit derivatives are instruments serving to trade credit
fail to comply with its obligations to service debt or the risk by isolating the credit risk from the underlying asset
counterparty will deteriorate in its credit standing (“reference asset”)
 Arises because promised cash flows on the primary  Allow separating the trading of the credit risk of assets from
securities held by FIs may or may not be paid in full (i.e. trading the asset itself
repayment default risk)  Allow credit risk to shift to another party
 It includes the risk that the payment will be delayed  Used to hedge, trade or customize credit risk
which may cause problems for the FIs (i.e. repayment  Used by banks (as buyers & sellers) to limit their credit
delay risk) exposure to a particular borrower, geographical area &
industry
Lillibeth Ortiz 6
Main Body Part 3: Credit Derivatives Main Body Part 3: Hedging Credit Risk With
Overview Total Return Swap
37 39
 Provide protection against:  Total return swap

 Credit events, such as default event  A party agrees to pay the total return (principal plus
 Rating downgrade or interest) on a particular reference asset (such as a bond
Deteriorate
 Change in credit spread
issued by a private borrower) & receive a rate such as LIBOR
in credit
or LIBOR plus a spread
standing
 Total return includes interest & unrealized capital gains /
losses
 If the bond incurs a capital loss, holder of credit derivative
receives an equivalent payment from the seller (gain on
swap offsets loss of loan market value)
Main Body Part 3: Hedging Credit Risk With Main Body Part 3: Hedging Credit Risk With
Credit Default Swap Credit Spread Products
40 42
 Credit default swap (pure credit swap)  Similar to other derivatives except the underlying is a
 Holder of bond or loan (who is also the buyer of the credit swap credit spread
or lender) makes a series of periodic payments to another party  Credit spread (CS)
(insurer)
 Risk premium = risky asset’s yield – risk free rate
 In event of default or a credit downgrade, insurer pays the holder
of the credit swap  Or could be differentials of credit spreads of two risky
assets
=> compensation given only if credit loss occurs. Otherwise,
holder receives nothing  Isolate effect of spreads (excludes interest rate variation)
 More like an insurance policy than a swap  2 types:
Note: Similar in payoff to a digital default option which pays a stated amount in

 Credit Forward
the event of a loan default, except that the premium is paid over the life of the
swap rather than at the initiation of the risk coverage as with the option.  Credit Spread Call Option
Main Body Part 3: Hedging Credit Risk With Main Body Part 3: Hedging Credit Risk With
Credit Forwards Credit spread call option
43 44
 Credit forwards (CF) hedge against decline in credit  Right to buy a future credit spread
quality of borrower, i.e., an increase in default risk on a  Payoff depends on the spread between a risky bond and a
loan risk-free bond
 Specifies a credit spread on a benchmark bond issued by a  Payoff increases as a (default) yield spread on a specified
bank borrower. benchmark bond on the borrower increases above some
 Example: BBB bond at time of origination may have 2% spread over exercise spread S.
U.S. Treasury of same maturity.  This offsets losses as the credit spread increases on the bank’s loan to
 After the loan is made, the bank sells a credit forward. If the the borrower, the value of the loan decreases.
credit risk of the borrower decreases sufficiently that the spread  Credit spread option buyer (protection buyer) pays a call
over the benchmark bond increases, the bank will realize a gain premium for the credit spread option
at the maturity of the forward contract that will offset the
decrease in value of the loan. Thus the bank benefits as the
credit risk of the borrower decreases.
Lillibeth Ortiz 7
Critical Thinking Conclusion

45 46
 Counterparty credit risk  Derivative securities have become increasingly important

 Increased risk in the 2008-2009 financial crisis: as FIs seek ways to hedge risk exposures. There are 3
basic types of derivatives: (1) forwards & futures, (2)
 Moral Hazard options, & (3) swaps. While several derivative types can
 Operational problems be used to hedge each risk, the more common ones are as
 Complexity follows:
 Swaps are the most popular instruments used to
 Systemic risk
manage interest rate risk.
 Forward or money market hedges, based on the
covered interest parity condition, are commonly used to
manage foreign exchange risk.
Conclusion References
47 48
 Credit default swaps have grown in volume significantly  References

to manage credit risks.
 Saunders: Chapters 23, 24, 25
 However, the growth of derivative usage is not without
controversy since misuse can increase risk (e.g., financial  Neal, R.S. ‘Credit Derivatives: new Financial Instruments for
crisis, AIG). Controlling Credit Risk’ from:
 Moreover, the enormous growth in the market for swaps www.kc.frb.org/publicat/econrev/ermain.htm
has raised serious regulatory concerns regarding
counterparty credit risk exposures.
Assignment Question #8 Exam Solution - Outline

49 50
 Discuss the characteristics of call and put options, and  Main Body Part 1.
 Briefly explain the structure of options
explain how these characteristics are useful in option-
 Identify the characteristics of call options and put options
based credit risk modelling
 Show payoff structures and how they differ between calls and puts
 Discuss the determinants of option prices and how each

factor influences the call and put option prices.
 No need to detail option pricing models.
 Discuss put options fully (indicates that you have read

beyond the subject guide)
Lillibeth Ortiz 8
Exam Solution - Outline Option Model: Shareholders’ Net Payoff

53 54
 Main Body Part 2.  Shareholder (borrower) has a _______ on the assets of

 Demonstrate how option pricing theory can be applied to the firm
credit risk Net Payoff to
 Holding equity is analogous to buying a call option on the value of share holders
the firm’s assets
 Holding debt is like writing a put option on the value of the firm’s
(borrower’s) assets
 Explain key points of the option-based credit model MV Assets (A)
0
 Key output: probability (over one-year) that the market value of A1 B A2
-E
assets will fall below promised repayments on short-term liabilities
At A1, owners of the firm will default & lose only E
At A2, owners will payoff the debt & are better off
FI Revision Classes / Lillibeth Ortiz / 2019 © 2018-2019 Lillibeth Ortiz – UOL Financial Intermediation
Option Model – Debt Holder’s Gross Loan

Option Model – KMV (Illustration)
Payoff
56 58
 Debt holder (bank) is writing a _______ on the value of

the borrower’s assets
At A2, i.e. MV of assets > value of promised debt value
Gross
repayment, the borrower will repay the loan &
Payoff to
bondholder get back B.
debt
A
holders If at A1, then bondholder will lose B – A1
time
0 1
MV Assets
0 (A)
A1 B A2
© 2018-2019 Lillibeth Ortiz – UOL Financial Intermediation © 2018-2019 Lillibeth Ortiz – UOL Financial Intermediation
Common Inaccuracies Common Inaccuracies

62 63
 Describing 2 types of options as European and American. These are ways  Not discussing how the different factors affect option prices – the
to exercise options. The common types of exercise are American and underlying asset price, strike price and volatility would correspond to the
European, but there are other types of exercise (e.g., Asian, barrier, etc). market value of the firm, face value of the debt and asset risk in part 2,
 Some said that the 2 types of options are long and short. These are the 2 respectively.
positions that you can take in options – buying (long, holding) or selling  For part 2, not explaining how the positions of shareholders or debt
(short, writing) an option contract. The 2 types of options are call options holders correspond to the long call and short put positions on the value of
and put options. the firm’s assets (the 2 main insights above), respectively.
 Assuming or implying stocks (or bonds) are the only type of underlying  Not discussing the key important factors that determine default probability
asset for options. according to the option-based model – these should be the market value
 Not describing the pay-offs of calls and puts when exercised; not showing of the firm and asset risk. However, the problem is that these factors are
their payoff diagrams. This is important, not only for part 1, but to link to not easily observable.
part 2, e.g.,  Not explaining how the KMV model addresses this problem by using equity
 Long call has limited loss when the underlying asset price falls and unlimited prices for publicly listed firms.
gains when the underlying asset price rises (like the shareholder’s pay-off)  Not explaining how the Expected Default Frequency is derived by the KMV
 Short put has limited gains when the underlying asset price rises and large model and not showing the probability diagram. It would be even better
losses when the underlying asset price falls (like the debt holder’s pay-off)
to give a simple example of computing the Expected Default Frequency.
Lillibeth Ortiz 9

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Financial Intermediation Revision

Learning Outcomes (Chapter 8) Learning Outcomes (Chapter 6)

Overview: Chapter 8 Overview: Chapter 6

Credit Credit Default

 Using credit derivatives as examples, explain the different

Similar Past Year Exam Questions Examiners’ Commentaries

Introduction Introduction: Derivatives

Overview: Chapter 8 Main Body Part 1: Hedging Interest Rate

Main Body Part 1: Interest Rate Swap

 Purpose of interest rate swap  Comparative Advantage

Main Body Part 2: Hedging FX Risk using Forward

Main Body Part 2: Hedging FX Risk using

 Alternative: money market hedge

the end of the tenure

 Provide protection against:  Total return swap

Critical Thinking Conclusion

 Counterparty credit risk  Derivative securities have become increasingly important

 Credit default swaps have grown in volume significantly  References

Assignment Question #8 Exam Solution - Outline

 Discuss the determinants of option prices and how each

 Discuss put options fully (indicates that you have read

Exam Solution - Outline Option Model: Shareholders’ Net Payoff

 Main Body Part 2.  Shareholder (borrower) has a _______ on the assets of

Option Model – Debt Holder’s Gross Loan

 Debt holder (bank) is writing a _______ on the value of

Common Inaccuracies Common Inaccuracies

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