CISI Exam Prep: Hedging Credit Risk – Case Studies and Strategies
Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives
Credit risk is the uncertainty about the ability of a debtor or the counterparty in an agreement to make a payment. Strategies for managing credit risk use traditional credit analysis techniques to screen counterparties and may also take advantage of hedging via derivatives.
Corporations frequently need to estimate the likelihood of defaults, the exposure, and the severity of loss from a default event. Taking into account these factors and market-based inputs, it is possible to estimate both expected and unexpected losses across a portfolio.
Expected credit losses can be statistically estimated over a period of time. Risk-adjusted credit loss provisions can then be set and factored into pricing as part of the normal cost of doing business. Unexpected losses form the basis for the credit risk capital-allocation process.
There are three main structures of derivative that enable an organization to manage credit risks more effectively.
With a credit default swap (CDS), a buyer purchases a contract and makes regular payments to a seller of credit protection. In the event of a default, the buyer receives compensation from the seller. This is commonly seen as an insurance policy for the buyer. It can, however, be used speculatively as there is no requirement for the buyer to hold any asset or have any potentially loss-making relationship with the so-called “reference entity.”
Total return swaps are similar to interest rate swaps. One side makes payments based on the total return from an asset. The other makes floating or fixed payments. The notional amount of the underlying asset is the same for both parties.
A credit-linked note (CLN) covers a specific credit risk. Investors receive a higher yield in return for accepting risk relating to a specific event. It provides a hedge for borrowers against an explicit risk. A CLN is created through a trust using very low-risk securities as collateral. Investors are paid a floating or fixed rate throughout the period of the note. At its completion they will either receive par or, if the reference entity has defaulted, the recovery rate value of the note.
Although swaps can be used to hedge against any sort of credit risk, they are easiest to explain through a notional case study of an instrument such as a bond. A fund may, for example, hold $8,000,000 of Mega Car Company’s five-year bond, and is concerned about the possibility of default due to market conditions arising from rising oil prices, increased government regulation on emissions, or the macroeconomic climate.
The fund decides to buy a credit default swap in a notional amount of $8,000,000 to cover the potential default value. The CDS in this case trades at 150 basis points, so the fund will pay 1.5% of $8,000,000, or $120,000 annually.
If Mega Car Company does not default, the fund will simply receive the full $8,000,000. In this case, its return will not be as good as it would have been without the CDS. On the other hand, if the corporation does default after, say, two years, the fund will receive its $8,000,000 from the seller of the CDS. It could be that the seller will take the bond or pay the difference between the recovery value and the par value of the bond.
Alternatively, Mega Car Company could make a breakthrough in low-emission technology and dramatically improve its credit profile. In that case the fund might decide to reduce its outgoings by selling the remaining period of the CDS.
- Derivatives such as a CDS will reduce or entirely remove the risk of default.
- The cost of hedging will reduce the return on investment.
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