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Subject 5. Other Derivatives PDF Download

Credit Derivatives

A credit derivative provides credit protection for the buyer in the event of loss from a credit event.

In a total return swap, the underlying is typically a loan or a bond. The credit protection buyer pays the credit protection seller the total return on the bond (interest plus capital) in return for a fixed or floating rate of interest. If the bond defaults, the credit protection seller must continue to pay the interest while receiving no (or very little) return from the buyer.

In a credit spread option, the underlying is the yield spread between the yield on a bond and the yield of a benchmark default-free bond. This yield spread, or credit spread, is a reflection of investors' perception of credit risk. The credit protection buyer selects the strike spread and pays an option premium to the seller. At expiration, the spread is compared with the strike spread, and if the option is in-the-money, the seller pays the buyer the determined payoff.

In a credit-linked note, the credit protection buyer usually holds a bond that may be subject to default and, to offset that risk, issues a credit-linked note with the condition that if the bond defaults, the principal payoff is reduced accordingly. Thus, the buyer of the credit-linked note takes on the credit risk of the underlying bond.

In a credit default swap, the credit protection buyer makes a series of regularly scheduled payments to the credit protection seller. The seller makes no payments until a credit event occurs. A credit event could be a declaration of bankruptcy, a failure to make a scheduled payment, or a restructuring. The CDS contract will explicitly define what constitutes a credit event. A CDS is essentially a form of insurance and provides loss coverage in return for the premium paid by the buyer to the seller.

Asset-backed Securities

Asset-backed securities are securities that are collateralized by a pool of securities such as mortgages, loans or bonds. Typically borrowers of mortgages, loans or bonds have the prepayment option to pay off their debts early.

When a mortgage asset portfolio is assembled into an ABS, the resulting instrument is called a collateralized mortgage obligation (CMO). When homeowners pay off their mortgages early (prepayment), the mortgage holders suffer, and an expected stream of returns has been terminated early. The funds now have to be reinvested at a typically lower rate. CMOs typically partition the mortgages into A, B, and C classes, and class C will bear the first wave of prepayment risk, followed by class B and class A. As the risk on the tranches is not equal (class C bears the most prepayment risk), the expected returns on the classes vary to compensate investors for the varying risk.

A collateralized loan obligations (CDO) does not have much prepayment risk but does have credit risk. A CDO allocates this risk to different tranches, senior, mezzanine, or junior tranches. When a default occurs, the junior tranche bears the risk first, followed by the mezzanine and then the senior tranche. Therefore, senior tranches have the lowest risk but also the lowest expected return.

Learning Outcome Statements

b. contrast forward commitments with contingent claims;

c. define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;

d. determine the value at expiration and profit from a long or a short position in a call or put option;

CFA® 2022 Level I Curriculum, Volume 5, Module 45

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