tested for their risk and return characteristics prior to commitment. Depending on the volume of the tranche and position in the loss distribution:
● Decreases in value of the reference pool have a magnified impact on expos- ure, and
● This can quickly lead to considerable loss of the nominal amount of the tranche.
While the investor remains exposed to the deterioration of a leveraged instru- ment, the originator bank usually protects itself against downgrading in credit quality by selling credit protection in the credit derivatives market, for assets contained in the reference pool. As already mentioned, hedge funds are active in this market. Insurance companies are also protection sellers.
In the event that the reference entity defaults, the buyer delivers to the seller debt owed by the defaulted entity, in return for a lump sum equal to the face value of the debt. Until credit risk transfer mechanisms have been developed, this kind of exposure was the domain and competence of commercial banks. Three basic types of recovery product are presently available on the market:
● Ordinary CDS contracts. With this instrument the value of protection is not known in advance. However, ordinary CDS contracts allow investors to separate recovery and default risk.
● Fixed recovery CDSs, also known as digital default swaps. Their character- istic is that the counterparties agree upon a recovery rate they will use after a credit event. A fixed recovery CDS buyer makes periodic payments to the seller, who provides protection to the buyer in case a credit event occurs.
● Recovery locks, or simple recovery swaps, where no cash flows are exchanged prior to a credit event. In the case of recovery locks, if a credit event occurs the seller delivers a defaulted obligation to the buyer in exchange for a pre- agreed fixed payment (specified in the contract), which represents the recovery value. Recovery swaps are quoted in terms of percentages of the notional principal amount and express the fixed recovery value that is exchanged after a credit event. Fixed recovery swaps and recovery swaps are closely linked.
Some people consider the more traditional credit default swaps as the ‘plain vanilla’ version of credit derivative instruments, probably because they are char- acterized by a simple algorithm, expressed in If … Then terms: if a given event takes place, then the protection seller must pay the agreed compensation to the protection buyer.
The pros answer that the concept of a swap is that simple, and by transferring credit risk from the protection buyer to the protection seller, ordinary credit default swaps have opened new business opportunities. Prior to them, it was not possible to short a loan; and moreover CDSs, which involve their own credit risk, help in price discovery:
● Price discovery is very important at a time when the market is in need of information about credit exposure, and
● The pricing of default swaps helps to reveal a great deal of market informa- tion about expected credit risk.
Theoretically, the price of a credit default swap is based on the financial service it provides – namely, insurance against companies defaulting on their financial
Risk Accounting and Risk Management for Accountants
138
Ch06-H8422.qxd 7/4/07 4:36 PM Page 138
obligations. In practice, this price is a market variable linked to investors’ credit risk appetite and other characteristics of the market’s behaviour.
Theoretically, recovery rates should be an important factor in determining the price of credit risk. When interest rates are rising and there is an increasing like- lihood of general credit conditions worsening, a great deal of attention should be paid to recovery rates. Experts suggest that a CDS premium, which is an expression of views by market participants about the price of credit risk, should reflect both:
● Probability of default of the reference entity, and
● Expected recovery value, should a credit event occur.
Protection buyers, however, do not know in advance the amount they would receive following a credit event, leaving them exposed to uncertainty about the ultimate recovery rate. This tends to be less important for investment-grade CDSs, because variations in their expected recovery rates tend to be low, the standard recovery values also tend to be low and the standard recovery rate used by the industry in pricing is 40%.
The other side of the equation is that recovery rates tend to be cyclical, declin- ing as economic conditions deteriorate. Changes in expected recovery values tend to be more relevant for lower credit quality names closer to default, because the actual recovery value of a defaulted security plays a crucial role in determin- ing the actual returns earned by affected investors.
Additionally, risk management connected to credit default swaps should pay attention to mismatches. In order to be able to benefit from purchased protection, when a credit event occurs, the buyer of protection needs to deliver the appro- priate amount of the defaulted reference entity’s obligation to the original protec- tion seller. Mismatches happen between:
● The amount of protection bought, and
● The volumes outstanding of the underlying debt instruments that could potentially be delivered.
An example is the case of Delphi, the car parts maker and former division of General Motors, which defaulted on its debts in 2005. As the company held an investment-grade rating until the end of 2004, it was referenced in a large num- ber of CDS indices and CDO transactions. It was also among the most frequently traded names in the CDS market. The challenge was created by the fact that:
● The amount of protection bought was estimated at more than $25 billion
● But the volume of outstanding Delphi obligations, including loans and bonds, amounted to less than $5 billion.
Chapter 6
139
Situations may arise whereby the prices of defaulted debt can soar to levels well above any reasonable recovery rate. When this happens, it can have broader neg- ative implications, as they may distort the fundamental valuations of defaulted assets, create problems with the physical settlement of derivatives contracts, and dent the confidence market players have in the instrument.