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An Introduction to Credit Derivatives PDF

164 Pages·2013·5.75 MB·English
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AN INTRODUCTION TO CREDIT DERIVATIVES SECOND EDITION People still crave explanations even when there is no underlying under- standingaboutwhat’sgoingon...erraticstockmarketmovementsalways find areadyexplanation inthenext day’sfinancialcolumns:aprice rise is attributed to sentiment that ‘pessimism about interest rate increases was exaggerated,’ or to the view that ‘company X had been oversold.’ Ofcoursetheseexplanationsarealwaysaposteriori:commentatorscould offeranequallyreadyexplanationifastockhadmovedtheotherway. ProfessorMartin Rees Our CosmicHabitat London: Phoenix(2003),page 101 AN INTRODUCTION TO CREDIT DERIVATIVES SECOND EDITION Moorad Choudhry AMSTERDAM(cid:129)BOSTON(cid:129)HEIDELBERG(cid:129)LONDON NEWYORK(cid:129)OXFORD(cid:129)PARIS(cid:129)SANDIEGO SANFRANCISCO(cid:129)SINGAPORE(cid:129)SYDNEY(cid:129)TOKYO ButterworthHeinemannisanimprintofElsevier Butterworth-HeinemannisanimprintofElsevier TheBoulevard,LangfordLane,Kidlington,OxfordOX51GB,UK 225WymanStreet,Waltham,MA02451,USA Firsteditionpublished1988 Secondeditionpublished2013 r2013,MooradChoudhryandElsevierLtd.Allrightsreserved TherightofMooradChoudhrytobeidentifiedastheauthorofthisworkhasbeen assertedinaccordancewiththeCopyright,DesignsandPatentsAct1988 Nopartofthispublicationmaybereproducedinanymaterialform(including photocopyingorstoringinanymediumbyelectronicmeansandwhetherornottransiently orincidentallytosomeotheruseofthispublication)withoutthewrittenpermissionofthe copyrightholderexceptinaccordancewiththeprovisionsoftheCopyright,Designsand PatentsAct1988orunderthetermsofalicenceissuedbytheCopyrightLicensingAgencyLtd, 90TottenhamCourtRoad,London,EnglandWIT4LP.Applicationsforthecopyright holder’swrittenpermissiontoreproduceanypartofthispublicationshouldbeaddressed tothepublisher PermissionsmaybesoughtdirectlyfromElsevier’sScienceandTechnologyRights DepartmentinOxford,UK:phone:(144)(0)1865843830;fax:(144)(0)1865853333; e-mail:[email protected] viatheElsevierhomepage(http://www.elsevier.com),byselecting‘CustomerSupport’ andthenObtainingPermissions’ Theviewsexpressedinthisbookareanexpressionoftheauthor’spersonalviewsonly anddonotnecessarilyreflecttheviewsorpoliciesofTheRoyalBankofScotlandGroupplc, itssubsidiariesoraffiliatedcompanies,oritsBoardofDirectors.RBSdoesnotguarantee theaccuracyofthedataincludedinthisbookandacceptsnoresponsibilityforany consequenceoftheiruse.Thisbookdoesnotconstituteanofferorasolicitationofanoffer withrespecttoanyparticularinvestment. Whilsteveryefforthasbeenmadetoensureaccuracy,noresponsibilityforlossoccasioned toanypersonactingorrefrainingfromactionasaresultofanymaterialinthisbookcanbe acceptedbytheauthor,publisheroranynamedpersonorcorporateentity. Nopartofthisbookconstitutesinvestmentadviceandnopartofthisbookshouldbe construedassuch.Neithertheauthornorthepublisheroranynamedindividualor entityissolicitinganyaction,responseortradeinresponsetoanythingwritteninthisbook. BritishLibraryCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheBritishLibrary LibraryofCongressCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheLibraryofCongress ISBN:978-0-08-098295-3 ForinformationonallElsevierButterworth-Heinemannfinance publicationsvisitourwebsiteathttp://books.elsevier.com/finance TypesetbyMPSLimited,Chennai,India www.adi-mps.com PrintedandboundinGreatBritain Dedication Dedicated to mywife,Lindsay Choudhry The streetof shame isa streetof hacks The menbehindthe men who do dealsbehind our backs The fourth estate isa houseof hate Media pimps with scant regards for facts They nail their victims with a telephoto to the ground Feed the peopleon scraps of evil And their dailydiet (cid:1)a platefulof hateful. Private greed,notpublicneed Life’sgeared to profit, money,wealth They can’t get enough of it. And inthe papers thesame oldstory Every picture sellsa Tory Money, profit, wealth, They can’t get enough of it, Money, profit, wealth Can’t get enough ofit.... —Redskins, APlatefulof Hateful(King/Dean/Hewes) from NeitherWashington nor Moscow, LondonRecords 1986 Reproducedwithpermission. About the Author Moorad Choudhry is Head of Treasury, Corporate Banking Division, at The Royal Bank of Scotland. He is Visiting Professor at the Department of Mathematical Sciences, Brunel University, and Visiting Teaching Fellow at the Department of Management, Birkbeck, University of London. Moorad is a Fellow of the Chartered Institute for Securities & Investment and a Fellow ofthe ifs-SchoolofFinance. Heisonthe Editorial Board of the Journal of Structured Finance and American Securitization, and isamemberoftheBoardofDirectorsofPRMIA. xi Foreword We are witnessing one of the most important episodes in financial history. The situation started with the crisis in the US financial system, is now challenging the European Union project and will hopefully fin- ish with some lessons learned and a more robust and efficient financial system. Arguably, the start of this crisis goes further back in time with years of excess leverage in the private sector ignited by low interest rates and prodigious financial innovations. The failure by some agents to identify the risks associated with such leverage and the interconnectivity of a global financial community has resulted in the difficult economic envi- ronment we are now experiencing. Governments had to step in and assume the excesses of the private sector to contain the effects of a dis- ordered asset reduction. The challenge is now of course the delever- aging of thepublic sector itself. At the heart of this financial innovation were credit derivatives. Traditionally the concept of credit was intimately linked to funding. One could not get exposure to a company without lending to it either through a bond or a loan. The introduction of credit derivatives was particularly important as it enabled the transfer of credit risk without funding or arelationship with theissuerof the underlying credit. A new world of possibilities was immediately created. Financial intermediaries could shape the risks of their portfolios through credit default swaps (CDS), buying and selling credit protection. Investors could have access to synthetically created customized products that ful- filled their requirements at virtually anytime. Credit worthiness was now truly an asset class of its own and credit derivatives expanded its applications as they transferred credit risk to counterparty risk. For lenders it is not only important to buy protection to offset the threat of default by a borrower, but it is equally important to assess the credit quality of the counterparty from whom the protec- tionisbought,as well as thecollateral terms. For instance,theexamples of AIG and Lehman have demonstrated the importance of introducing counterparty value adjustments (CVA). Much has been written about the role of credit derivatives in the development of the actual economic situation. In fact, a great part of xiii xiv FOREWORD what has been written condemns credit derivatives. But as with many other innovations in history, it is the usage and not the tool that creates theproblems. As over-the-counter (OTC) instruments, credit derivatives practi- tioners have been involved through different industry bodies, mainly theInternationalSwapsandDerivativesAssociation(ISDA),instrength- eningthedocumentationandmakingtheliquidationprocessofdefaults transparent, responding to challenges as they arose. This has been a good start and sets solid ground, but is not enough. Challenges remain tobeaddressed,suchtheconcentrationoftheindustrywithinahandful of counterparties, and the migration to central clearing counterparties (CCPs)tomitigatecounterpartyrisk. Policy makers have been busy preparing new regulations with the aim of implementing them as soon as possible hoping to avoid the mis- takes of the past. Dodd-Frank, the Volcker Rule, BIS3 and CRD4, MiFID, Sovency II, among others, contain very plausible measures for financial institutions and insurers, but as the drafting of these rules is evolving a clear and timely implementation would be desirable to have arobust regulatory framework in thefuture. It is therefore important to understand the credit product and have all the relevant information to be able to diligently get involved with credit derivatives. In this valuable book you will be able to learn about thetheory,insights,usages andimplications ofcreditderivatives. Finally, we have now the possibility of reflecting on previous finan- cial crises to understand how they eventually came to an end, and we have a unique opportunity to make sure that new such episodes are not repeated. Better information and a responsible application of financial innovation should guarantee an efficient flow of capital to help the development of prosperous andsustainablegrowth. Juan Blasco Head ofCreditProducts WholesaleBankingand Marketing Lloyds Bank Group 19October 2012 Preface Finance is a dry, unemotional subject. At least, it should be. Discussing any aspect of it should not be a cause for undue stress or argument. It isn’t as if one is debating abortion rights or the Arab(cid:1)Israeli peace process when one enters into a conversation on financial products. Any discourse in this field should be logical and objective, aimed at arriving at a sound solution that meets the needs of therelevant stakeholders. Sadly, in the era following the banking crash of 2008, when the US and a number of European governments had to spend a considerable sum of taxpayers’ money saving their banking sector, we encounter considerablesubjective andemotionaldebateinfinance.Somecommen- tators have suggested that ‘CDOs’ caused the financial crash. Others, including some so-called ‘gurus’ best known for specific trades they may have undertaken over 20 years ago or who worked in banking over 30 years ago, have suggested that credit default swaps (CDS) caused thecrash and should bebanned to prevent the next crash. This is utter nonsense. Financial instruments didn’t cause the crash any more than tulips caused the crash of 1637 or Gordon Gekko caused the crash of 1987. A number of factors, working in concert, combined to produce a market correction and what all crashes have in common is speculation, mis-pricing, greed, applying incorrect or inaccurate assumptions and an inept understanding of the basic principles of finance. For tulips we can substitute sub-prime mortgages, for example, but on its own a financial instrument does not cause a crash. If used in a certain way certain products may make it easier for the effects of mis- pricing to be transferred more quickly across the market, but of itself it is financially illiterate to suggest that CDOs or CDS caused the crash. To do so only reflects subjective andemotional thinking. This book isn’t about the crash of 2008 or indeed any other crash. Rather, it is an introduction to a particular type of bank risk manage- ment product known as the credit derivative. The emergence of this product in the financial markets in the mid-1990s resulted in a repeat of the classic ‘tail wagging the dog’ scenario that one had observed in the 1980s, when interest-rate derivatives were introduced. Now the princi- pal instrument used for valuation and analysis of the credit asset class xv

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The second edition of An Introduction to Credit Derivatives provides a broad introduction to products and a marketplace that have changed significantly since the financial crisis of 2008. Author Moorad Choudhry gives a practitioner's perspective on credit derivative instruments and the risks they in
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