A Risk Neutral Framework For The Pricing Of Credit Derivatives
1. INTRODUCTION
Considerable research effort has gone into Credit Derivatives since the early 1990’s. The roots of credit derivatives can be traced back to the notion that the credit risk of a firm can be captured by the credit rating ascribed to it. This premise is also the cornerstone of loan pricing and credit risk management models the world over, including J.P. Morgan’s CreditMetricsTM.
Empirical research enables the predictability of the event of default as well as the Loss in the Event of Default (LIED). This information is expressed in terms of a ‘transition matrix’ - a matrix that traces out the probabilities the migration of a firm’s credit rating. Rating agencies such as Standard & Poor (S&P) provide transition matrices computed from periods of data about bonds - default record and post-default behaviour in the US markets. Lack of adequate data precludes the computation of such matrices in the Indian context, although it is possible to map ratings of Indian rating agencies such as CRISIL onto S&P ratings.
2. TYPES OF CREDIT DERIVATIVES
Here is a brief description of some popular types of credit derivatives:
2.1 Credit Default Swaps
A credit default swap provides a hedge against default on some payment, such as a bond. The counterparty buying credit protection pays the provider a certain amount in return for a guarantee to make good the loss in the event of default.
2.2 Total Return Swaps
In this contract, the ‘payer’ gives a ‘receiver’ the total return on an asset in return for the returns on a benchmark asset, typically a risk-free asset. The payer has thus eliminated the risk of default in return for a lower but certain risk-free rate of return.
2.3 Credit Spread Derivatives
Credit spread derivatives take the form of credit spread options, forwards or swaps. A credit spread call option, for example, is a call option written on the level of the spreads for a given bond. The option, thus increases in value as the spread increases, so that the value of the bond is protected.
3. RISK-NEUTRALITY
Hypothesising the existence of a ‘risk-neutral’ world is extremely useful in the pricing of instruments whose value is derived from a stochastic process. In the real world, the present price is less than the expected net present value of the likely outcomes in future. Thus, for example, if the price of a commodity can become either Rs.
Bernd C Kieseier, and Hans-Peter Hartung. Also used for this paper was the article “The risk of
a high chance of loss. The Investor must control his nerves when ups or downs come, thus pricing is much more important than timing. This subject will be discussed further in the next chapter. The price is determined by the investors evaluation and not by the average price, which can result from poor competence from the Enterprise’s side (Buffett Books K, 2017).
The transferor gives the transferee an entire or a restricted amount of recourse in the transfer of a full receivable, a class of a full receivable, or a small amount of the full receivable with recourse. The transferor is obliged under the full agreement of the recourse provision to pay the transferee or to just rebuy the receivables bought under convinced circumstances. Ideally this is for defaults that are at a percentage of the amount specified.
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Adair Jr., T. A., Cornett, M. M., & Nofsinger, J., (2012). Finance: Applications and Theory, Second Edition. New York, NY.McGraw Hill.
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Midway through 2007 financial markets began to collapse on news of heavy write-downs by major financial institutions. The housing market in the United States (US), which had been experiencing consistent growth since 1975, began to contract in the third quarter of that year while the delinquency rate had been rising since 2006 (Mortgage Bankers Association, 2008). Investors were uncertain how severe the losses would be but it was becoming more likely by the end of the year that a financial crisis was imminent: the amount of subprime and collateralized debt obligation (CDO) losses had surpassed US$120 billion and were expected to increase in 2008 (Gaffen, 2008). As economic conditions turned from bad to worse investors, academics and practitioners began to wonder how such a crisis could have been precipitated in the first place. Blame was placed on mortgage originators, the Federal Reserve and on the investment banks, to name a few. The credit rating agencies (CRAs), seldom in the spotlight, were also heavily criticized for their role in causing the crisis. CRAs certainly do play an important part in financial markets and Thomas Friedman, the Pulitzer Prize winning New York Times columnist, once remarked that there are two superpowers in the world: the US and Moody’s (Lowenstein, 2008). But did the CRAs really deserve blame or were they being held as scapegoats? In the past the agencies generally avoided significant criticism for their rating of corporate debt and government issues, but their role in the burgeoning structured finance market in the early 2000s was characterized by conflict of interest issues, poor risk modeling and ineffective government regulation. As a result low quality ratings proliferated the mar...
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Kim, J. (2008). From Vanilla Swaps to Exotic Credit Derivatives: How to Approach the Interpretation of Credit Events. Fordham Journal of Corporate & Financial Law, 13(5), 705+.
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