inefficiencies in the way these counterparties are treated from a regu- latory perspective means the capital assignment differs and hence the return.
simply because the reference asset can change adversely in value due to changes in the general level of interest rates which have nothing to do with a credit event. The reference asset will obviously be a very strong credit.
Substitution
If the reference asset is materially reduced then the calculation will be based upon a substitute issue. The reduction can be due to a number of contingencies including illiquidity and debt buy backs.
Basis risk
Basis risk is a term employed more generally within the derivatives market. It refers to the risk undertaken because the hedge is a poor proxy for the asset we are seeking to protect. We illustrate by taking an extreme example. If I had a portfolio consisting of the FT-SE 100 shares, I could hedge this by selling a share of Vodafone in the correct proportion. It would not be a very good hedge because the index is composed of shares additional to Vodafone.
Returning to the credit derivative world the assets on which I am seek- ing protection is often poorly correlated with the reference asset poten- tially, because of materiality or substitution.
You should also be aware that the documentation changes consid- erably depending on whether protection is provided on either a sovereign or corporate name. For example both the term sheet (of which examples are presented for each derivative type) and the details of the ISDA obli- gation and deliverable categories and characteristics vary.
There are moves towards an international framework but many of the details including the number of items on the list above is under debate, in particular the inclusion of acceleration and moratorium are under review. Furthermore there are a number of grey areas surrounding the precise nature of an event. Major discussions concern the definition of restructuring and the determination of the reference asset. A specific example is provided by the case of Rank Xerox extending the maturity on its debt in June 2002. Protection sellers argued that this was not a restructuring caused by deterioration in creditworthiness. Furthermore the demerger of National Power begged questions as to the location of the reference entity and obligation post-merger.
Legal technicalities aside there remains the pure quantitative aspects of what constituents a fair value for the protection premium and finally the value of the contingent payment?
Following further discussion with market participants ISDA has sched- uled a new release of documentation for implementation in May 2003.
This was partially in response to the controversy that had developed surrounding the interpretation of restructuring and demerging.
2003 Update
Specifically the renegotiation of bilateral loans may no longer trigger a credit event. A new clause is inserted stating that a credit event can be defined as a restructuring only if the obligation is held by more than three non-affiliated holders.
Under the new methodology if one of the demerged entities inherits three quarters or more of the original debt then it becomes the suc- cessor in the contract. If the new entities have between a quarter and three quarters then the CDs protection is split. If the demerged enti- ties have less than one quarter and the parent still exists then there is no change in the contract. If the parent ceases to exist then the entity taking possession of the larger fraction is the subject of the new contract.
Definition of bankruptcy as a credit event
A bankruptcy can only have occurred if the default occurs on the reference entity itself. For all other credit events the default can occur on any obligation.
Four types of restructuring clause
These clauses, applicable to corporates, came into effect because of so-called ‘soft default’. This is different from ‘hard default’ comprising bankruptcy and failure to pay. Following a ‘hard’ event, all the entities debt will be similarly affected. However subsequent to a ‘soft’ event, there are considerable valuation differences. This had opened up a cheapest to deliver opportunity for the seller:
• No restructuringeliminates the seller incurring losses due to deteri- oration in the reference obligation not due to default.
• Full: The buyer can deliver bonds of any maturity after debt restructuring.
• Modified and modified restructuring: The buyer is restricted to the types of bonds that can be delivered in terms of maturity.
Definition of deliverable obligations
These are now defined to suit the needs of the counterparties:
• The direct obligation of the reference entity.
• The obligations of a subsidiary (to qualify the subsidiary must have more than 50 per cent owned by the reference entity).
• Obligations of third parties guaranteed by the reference entity.
References
Altman and Kishore, Defaults and Returns on High Yield Bonds, New York University Salomon Centre, 1997.
Carty and Lieberman, Corporate Bond Defaults and Default Rates, Moody’s Spe- cial Report, 1996.
Caouette, Altman and Narayanan, Managing Credit Risk: The Next Great Finan- cial Challenge, Wiley.
Leander, Robeco’s Synthetic Age, Risk, March 2002.
Masters et al., The JP Morgan Guide to Credit Derivatives, Risk Metrics Group.
O’Kane, Credit Derivatives Explained, Lehman Brothers.
O’Kane and McAdie, Trading the Default Swap Basis, Risk,October 2001.
O’Kane and Turnbull, Valuation of Credit Default Swaps, Lehman Brothers.
Tavakoli, Credit Derivatives: Guide to Instruments and Applications, Wiley.