Credit Products and Derivatives

Day One

Credit Products – Corporate Bonds, Credit Default Swaps and Managing Credit Risk

Introduction To Credit Market

• Overview of the corporate bond market – history, market size, key players, applications
• Measuring credit spreads – spreads to government benchmarks, I-spreads, z-spreads, par asset swap spreads
• What drives credit spreads – fundamental and technical drivers?

Single Name Credit Default Swaps (CDS)

• Product description
• Market background – history, market size, key players, applications
• Standard credit events – bankruptcy, failure to pay, restructuring, (government intervention)
• Restructuring conventions – maturity limitation, restructuring bucketing, and economic implications. Case Study 1– Allied Irish Banks Plc (Irish bank) subordinated CDS curve shape highly sensitive to which credit event transpired
• Credit event determination – decision process of the ISDA Determinations Committee
• Settlement – how does the CDS auction process work? Case Study 2– Codere SA (international gaming company)
• Standardized coupons and annuity risk
• Extracting survival probability curve from CDS curve
• Calculating CDS NPV and sensitivity parameters (CS01 and recovery delta). Case Study 3: Alcatel-Lucent (telecom equipment manufacturer)
• Bloomberg CDSW tool – CDS pricing conventions & ISDA Standard Model
• Key CDS conventions – Europe, US, Asia
• ISDA 2014 Credit Derivatives Definitions – specific treatment of European bank and sovereign contracts
• Applications – sell side and buy-side; expressing credit views; hedging bond portfolios; pair trades; CLNs; curve trades; hedging loan portfolios

Workshop 1: Pizza Express (restaurant company) – Calculating NPV of credit default swap and testing its sensitivity to credit curve shape and recovery rate. Extracting survival probability curve. Comparing results to Bloomberg CDSW

Index CDS & Index CDS Options

• Product description
• Market background – history, market size, key players, applications
• What happens when an index constituent experiences a credit event? Case Study 4:  iTraxx Europe Crossover S23 and Norske Skogindustrier ASA (distressed newsprint and magazine paper producer)
• Index skew – calculation, historical range, and trading
• Selection criteria and process for CDS index constituents. Case Study 5: Alstom SA (capital goods manufacturer) and Metsa Board Corporation (paper and packaging producer). What impact do index inclusion and exit have on single names?
• Major CDS indices and relationships between them - Europe, US, and Asia
• How do CDS indices correlate to other asset classes (equities and government bonds)?
• Correlation of CDS indices with corporate bond indices - calculating beta-adjusted hedge ratios
• Liquidity and execution

CDS Index Options

• Product mechanics – payers and receiver swaptions
• Options strategies
• Pricing – CDS forwards and options
• Risk management – calculating and hedging greeks; what do skew and smile look like in credit volatility space?

Managing a CDS Portfolio – Market Risk

• Key risk metrics for a CDS portfolio – CS01, CS100, DTS, jump risk, theta, curve risk, recovery delta, sector risk, country risk, subordination risk, VAR, sVAR, expected shortfall. Case Study 6: Calculating and interpreting risk metrics for a CDS portfolio
• Carry and rolldown – understanding rolldown P&L on IMM roll date. Case Study 7: Building a rolldown P&L estimation tool

Managing a CDS Portfolio – Opportunities and Pitfalls Not Well Captured by Market Risk Metrics

• CDS curve shapes – curve behavior in distress. Case Study 8: Understanding the CDS curve shape for Noske Skogindustrier ASA (distressed newsprint and magazine paper producer)
• CDS orphaning. Case Study 9: Grohe AG (bathroom products manufacturer)
• CDS succession and splits.Case Study 10: Hilton Group Plc demerger of hotels business. Case Study 11: Banco Espirito Santo SA good bank-bad bank split
• Bank subordinated/senior CDS relationship and absence of bank subordinated CDS deliverables. Case Study 12: SNS Bank N.V. (failed Dutch bank)
• CDS of leveraged buyout candidate. Case Study 13: J. Sainsbury Plc (UK food retailer)

Workshop 2: Building and interpreting a market risk report for a CDS portfolio 

Day Two

CDS Infrastructure and Structured Credit Derivatives

CDS Infrastructure

• Understanding ISDA and CDS agreements in relation to CDS
• Trade confirmations/matching and trade reporting to trade repositories (DTCC, ICE). Case Study 14: Sample trade and operational process that follows
• Novations and terminations – mechanics and matching through consent platforms (DTCC, ICE). Case Study 15: Sample novation and operational process that follows
• Counterparty credit risk on CDS. Case Study 16: How a CVA desk manages counterparty credit risk on CDS
• Central clearing – mechanics, margin requirements, loss waterfall, responsibilities of operations team. Case Study 17: Sample iTraxx Europe trade cleared at ICE and operational process that follows

Price Verification

• Price verification/marking – assessment of data sources (MarkIT, Bloomberg) and third party valuation services. Case Study 18: Required inputs for third party valuation services and quality surveillance of outputs
• Case Study 19: Building in-house CDS valuation engine into which third party curves can be input
• P&L effects through time from trading with standardized coupons and Bloomberg CDSW upfront calculation convention (flat curve and standard recovery rate), whilst marking off correct, non-flat curve, and potentially different recovery rates

Compliance Requirements

• Mandatory central clearing requirements for CDS in US and Europe
• EU sovereign short selling restrictions in CDS – understanding permissible hedges and hedge correlation tests
• Case Study 20: Hedge correlation test on hedging EU bank CDS with sovereign CDS

Compression Services

• Why do they exist and how do they work?
• Case Study 21: Compression with Trioptima

Structured Credit Derivatives

Leveraged CLNs

• What is a CLN?
• CLN benefits for investors and for issuer/originator banks
• Bank-issued and Special Purpose Vehicle (SPV)-issued CLN structures
• Overview of common CLN underlyings
• Leveraged CLNs
• Gap risk
• Case Study 22: Example 3x leveraged CLN
• Pricing gap risk – pricing deep out-of-the-money CDS options with a jump-based stochastic spread process; liquidity costs
• Hedging – first order risks; hedging gap risk using CDS options and recovery swaps; syndicating gap risk out to other investors
• Risk management – setting gap risk limits; setting stop-loss or leveraged CLN unwind triggers; syndicating gap risk out to other investors; basis risks arising from CLN customization; gap risk modeling for VAR, sVAR, and expected shortfall purposes

Quanto CDS

• What is quanto CDS?
• Quanto CDS pricing – FX depreciation on default, FX volatility, spread volatility and correlation between spread and FX changes
• Realized spread and FX volatility and correlation. Implied FX depreciation on default
• Case Study 23: Implied FX depreciation on default in peripheral European sovereign debt crisis 2011-2012
• Case Study 24: Historical sovereign defaults and FX depreciation
• Implied volatilities – CDS index options and FX options
• Case Study 25: Calculating implied spread and FX volatilities for use in quanto CDS pricing
• Quanto CDS pricing as a knock-in FX option
• Using Monte Carlo simulation to price quanto CDS and ensure capture of hedging costs
• Case Study 26: Quanto CDS pricing using Monte Carlo
• How do quanto CDS positions typically arise on dealer trading books? Right way and wrong way quanto CDS positions
• Hedging quanto CDS positions – creating a quanto spread market; dynamic FX hedging; recovery swaps; out-of-the-money FX options; hedging transaction cost estimation and ensuring capture of these in pricing

Workshop 3: Pricing and hedging a 3x leveraged CLN

Day Three

Structured Credit Derivatives (Cont.)

Nth To Default Basket (CLNs)

• What are First to Default (FTD) and nth To Default (NTD) baskets?
• Buyer and seller motivations
• Pricing baskets intuition – constituent spreads and default correlation
• Case Study 27: Illustrated basket pricing sensitivities
• Copula functions – linking single issuer survival probability curves with joint survival probability curves
• Building the correlation matrix – realized vs. implied from tranche markets
• Case Study 28: Calculating implied correlation surface from iTraxx Europe tranches
• Pricing baskets – Gaussian factor models; modeling firm value; modeling conditional default probability; probability of n defaults; unconditional default probability; nth to default basket pricing
• Case Study 29: Pricing FTD and NTD baskets on a portfolio of Asian reference entities
• Hedging – spread delta; recovery delta; convexity (iGamma and market gamma); correlation; granularity; credit quality; homogeneity
• Case Study 30: Calculating Greeks for FTD and NTD baskets
• Risk management – model validation; correlation limit setting
• Valuation – correlation marking of non-standardized baskets

Tranched Products – Synthetic CDOs and Standardized Index Tranches

• What is a synthetic CDO or collateralized synthetic obligation (CSO)?
• Who invests in the different tranches and why?
• Pre- and post-crisis CSOs compared
• CSOs as an extension of FTD/NTDs
• CSO pricing – spread dispersion, correlation, and Copula functions
• Case Study 31: Pricing senior, mezzanine, and equity tranches of a CSO
• What is a standardized index tranche?
• Implied correlation
• Managing a correlation book with bespoke CSOs, standardized index tranches, and NTD positions

Workshop 4: Pricing FTD and NTD baskets on portfolio of sovereigns, banks and corporates; calculating Greeks; setting up the hedges at inception; dynamic hedging for a given path of spread changes

Fixed/Zero Recovery CDS and Recovery Swaps

• Fixed recovery CDS – investor motivation
• Pricing fixed/zero recovery CDS off standard CDS – payoff ratios. Pricing the residual recovery risk
• Case Study 32: How much should a dealer pay for zero recovery CDS?
• Hedging fixed/zero recovery CDS with standard CDS. Mark-to-market (MTM) on the hedged position
• Case Study 33: Calculating MTM at a future point in time on zero recovery CDS
• Risk management – recovery limits
• Recovery swaps – a combination of a standard recovery and fixed recovery CDS
• Recovery locks
• Recovery swap payouts
• Applications of recovery swaps
• Valuation of recovery swaps and locks – MTM; use of Bloomberg CDSW calculator; sensitivities – traded recovery level, spread, time value
• Case Study 34: Calculating MTM on recovery swap and recovery lock
• Historic CDS auction results analysis

Workshop 5: Calculating recovery swap MTM