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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 behaviour 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 modelling 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; modelling firm value; modelling 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



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