Moreover, in contrast to forward commitments, which have payoffs that are linearly related to the payoffs of the underlying (note the straight lines in Exhibit 1), contingent claims have payoffs that are non-linear in relation to the underlying. There is linearity over a range – say, from 0 to X or from X upward or downward – but over the entire range of values for the underlying, the payoffs of contingent claims cannot be depicted with a single straight line.
We have seen only a snapshot of the payoff and profit graphs that can be created with options. Calls can be combined with puts, the underlying asset, and other calls or puts with different expirations and exercise prices to create a diverse set of payoff and profit graphs, some of which are covered later in the curriculum.
Before leaving options, let us again contrast the differences between options and forward commitments. With forward commitments, the parties agree to trade an underlying asset at a later date and at a price agreed upon when the contract is initiated. Neither party pays any cash to the other at the start. With options, the buyer pays cash to the seller at the start and receives the right, but not the obligation, to buy (if a call) or sell (if a put) the underlying asset at expiration at a price agreed upon (the exercise price) when the contract is initiated. In contrast to forwards, futures, and swaps, options do have value at the start: the premium paid by buyer to seller. That premium pays for the right, eliminating the obligation, to trade the underlying at a later date, as would be the case with a forward commitment.
Although there are numerous variations of options, most have the same essential features described here. There is, however, a distinctive family of contingent claims that emerged in the early 1990s and became widely used and, in some cases, heavily criticized. These instruments are known as credit derivatives.
Credit risk is surely one of the oldest risks known to mankind. Human beings have been lending things to each other for thousands of years, and even the most primitive human beings must have recognized the risk of lending some of their possessions to their comrades. Until the last 20 years or so, however, the management of credit risk was restricted to simply doing the best analysis possible before making a loan, monitoring the financial condition of the borrower during the loan, limiting the exposure to a given party, and requiring collateral. Some modest forms of insurance against credit risk have existed for a number of years, but insurance can be a slow and cumbersome way of protecting against credit loss. Insurance is typically highly regulated, and insurance laws are usually very consumer oriented. Thus, credit insurance as a financial product has met with only modest success.
In the early 1990s, however, the development of the swaps market led to the creation of derivatives that would hedge credit risk. These instruments came to be known as credit derivatives, and they avoided many of the regulatory constraints of the traditional insurance industry. Here is a formal definition:
A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and a credit protection seller, in which the latter provides protection to the former against a specific credit loss.
One of the first credit derivatives was a total return swap, in which the underlying is typically a bond or loan, in contrast to, say, a stock or stock index. The credit protection buyer offers to pay the credit protection seller the total return on the underlying bond. This total return consists of all interest and principal paid by the borrower plus any changes in the bond’s market value. In return, the credit protection seller typically pays the credit protection buyer either a fixed or a floating rate of interest. Thus, if the bond defaults, the credit protection seller must continue to make its promised payments, while receiving a very small return or virtually no return from the credit protection buyer. If the bond incurs a loss, as it surely will if it defaults, the credit protection seller effectively pays the credit protection buyer.
Another type of credit derivative is the credit spread option, in which the underlying is the credit (yield) spread on a bond, which is the difference between the bond’s yield and the yield on a benchmark default-free bond. As you will learn in the fixed-income material, the credit spread is a reflection of investors’ perception of credit risk. Because a credit spread option requires a credit spread as the underlying, this type of derivative works only with a traded bond that has a quoted price. The credit protection buyer selects the strike spread it desires and pays the option premium to the credit protection seller. At expiration, the parties determine whether the option is in the money by comparing the bond’s yield spread with the strike chosen, and if it is, the credit protection seller pays the credit protection buyer the established payoff. Thus, this instrument is essentially a call option in which the underlying is the credit spread.
A third type of credit derivative is the credit-linked note (CLN). With this derivative, the credit protection buyer holds a bond or loan that is subject to default risk (the underlying reference security) and issues its own security (the credit-linked note) with the condition that if the bond or loan it holds defaults, the principal payoff on the credit-linked note is reduced accordingly. Thus, the buyer of the credit-linked note effectively insures the credit risk of the underlying reference security.
These three types of credit derivatives have had limited success compared with the fourth type of credit derivative, the credit default swap (CDS). The credit default swap, in particular, has achieved much success by capturing many of the essential features of insurance while avoiding the high degree of consumer regulations that are typically associated with traditional insurance products.
In a CDS, one party – the credit protection buyer, who is seeking credit protection against a third party – makes a series of regularly scheduled payments to the other party, the credit protection seller. The seller makes no payments until a credit event occurs. A declaration of bankruptcy is clearly a credit event, but there are other types of credit events, such as a failure to make a scheduled payment or an involuntary restructuring. The CDS contract specifies what constitutes a credit event, and the industry has a procedure for declaring credit events, though that does not guarantee the parties will not end up in court arguing over whether something was or was not a credit event.
Formally, a credit default swap is defined as follows:
A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
A CDS is conceptually a form of insurance. Sellers of CDSs, oftentimes banks or insurance companies, collect periodic payments and are required to pay out if a loss occurs from the default of a third party. These payouts could take the form of restitution of the defaulted amount or the party holding the defaulting asset could turn it over to the CDS seller and receive a fixed amount. The most common approach is for the payout to be determined by an auction to estimate the market value of the defaulting debt. Thus, CDSs effectively provide coverage against a loss in return for the protection buyer paying a premium to the protection seller, thereby taking the form of insurance against credit loss. Although insurance contracts have certain legal characteristics that are not found in credit default swaps, the two instruments serve similar purposes and operate in virtually the same way: payments made by one party in return for a promise to cover losses incurred by the other.
Exhibit 5 illustrates the typical use of a CDS by a lender. The lender is exposed to the risk of non-payment of principal and interest. The lender lays off this risk by purchasing a CDS from a CDS seller. The lender – now the CDS buyer – promises to make a series of periodic payments to the CDS seller, who then stands ready to compensate the CDS buyer for credit losses.
EXHIBIT 5 Using a Credit Default Swap to Hedge the Credit Risk of a Loan
