Credit Derivatives Research Articles

Polynomial approximation of discounted moments

AbstractWe introduce an approximation strategy for the discounted moments of a stochastic process that can approximate the true moments for a large class of problems. These moments appear in pricing formulas of financial products such as bonds and credit derivatives. The approximation relies on a high-order power series expansion of the infinitesimal generator and draws parallels with the theory of polynomial processes. We demonstrate applications to bond pricing and credit derivatives. In the special cases that allow an analytical solution, the approximation error decreases to around 10 to 100 times machine precision for higher orders. When no analytical solution exists, we numerically compare the approximation with existing numerical techniques.

The Effect Of Credit Derivatives On Hedging Risk Of Non-Payment: Applied Research

The purpose of the current research is to reveal the impact of credit derivatives by (purchased credit derivatives, the value of credit derivatives sold) in hedging the risk of non-payment at a sample of commercial banks in the Iraq Stock Exchange by (Middle East Bank, Gulf Commercial Bank, Trade Bank of Iraq, Bank of Baghdad, Credit Bank) for the financial period from (2016-2020), and for the purpose of analyzing the results, the Office package was adopted (Excel.V.2016) in order to extract the level of credit derivatives, And the risks of non-payment at the commercial banks surveyed, has been using a set of statistical methods to determine these variables, represented in (credit derivatives, arithmetic mean, correlation coefficient, and regression coefficient), as a result, the research came out with a set of results, foremost of which was that there is an effect of credit derivatives in hedging the risks of non-payment, and this shows that credit derivatives contribute to improving the ability to hedge against non-payment risks, allowing investors to reduce financial risks. The focus of the surveyed commercial banks on the use of credit derivatives to protect investors from fluctuations in interest rates and currency rates, which works to reduce the impact of non-payment risks on their profits, which means that these contracts allow the determination of a future price for financial assets.

Modeling and pricing credit risk with a focus on recovery risk

Consider a defaultable bond traded in a financial market that is subject to shocks and regime shifts. Its recovery payment has a hybrid structure, comprising two components: one contingent on historical information up to the time of default, and the other an independent variable indexed by the regime at the time of default. The default intensity, interest rate, and reference rate are assumed to be general deterministic functions of certain state variables, while these state variables jointly follow a jump-diffusion process, with drift and volatility coefficients governed by the regime and with jumps induced by shocks. We construct a risk-neutral pricing measure that prices all risk sources in an integrated manner. A rigorous verification of this pricing measure reveals the corresponding time-dependent market prices of these risk sources. The resulting pricing framework is applicable to most defaultable bonds and credit derivatives.

CREDIT DERIVATIVES: TRADING PROTECTION

The article describes the main forms of credit derivatives, the evolution of their development and conditions of use. Particular attention is paid to the conditions of protection against credit risk. The authors demonstrate the possibility and expediency of using credit derivatives in the financial practice of Ukrainian companies in the context of transformation of the current legislation. It is established that credit notes, as a form of credit derivatives, are a more reliable financial instrument. From an economic point of view, they are considered to be securities with a certain set of risks and benefits for investors, which should be taken into account when developing a financial strategy for all capital market participants. The subject of the study is the intricacies of using credit derivatives in financial management, with a special emphasis on their role and conditions in modern Ukrainian financial practice. The research methodology includes a critical review of the existing literature combined with an analysis of the current use of credit derivatives in Ukraine. This approach offers a dual perspective that not only summarises the global context but also takes into account the nuances of local implementation. The purpose of this study is to investigate the effectiveness of credit derivatives as financial instruments for risk hedging and profitability optimisation. By examining different types of these instruments, the study aims to draw practical conclusions and provide recommendations for integrating these instruments into financial management practices in Ukraine. The research concludes that credit derivatives offer significant advantages as reliable financial instruments that contribute to risk management and economic development. The paper highlights their potential to positively impact financial market development, especially under conditions that facilitate risk hedging. The findings of the publication support the creation of a specific legislative and regulatory framework that would facilitate the wider introduction and efficient use of credit derivatives in Ukraine. This includes emphasising the need for specific amendments to existing tax codes and financial regulations to create a favourable environment for these instruments.

Effective credit risk mitigation strategies: Solutions for reducing exposure in financial institutions

Credit risk remains a critical concern for financial institutions, especially in the context of economic uncertainties and volatile market conditions. This paper examines the importance of credit risk mitigation strategies and presents solutions for reducing exposure in financial institutions. The research focuses on various strategies employed by banks and other financial institutions to manage credit risk effectively. The paper begins with an overview of credit risk and its significance in the banking industry. It discusses the various types of credit risk faced by financial institutions, including default risk, concentration risk, and systemic risk. The paper then highlights the importance of credit risk mitigation strategies in reducing the impact of these risks on financial institutions' balance sheets and profitability. Next, the paper explores different credit risk mitigation strategies used by financial institutions. These strategies include diversification of credit portfolios, collateralization of loans, credit derivatives, and credit insurance. The paper discusses the advantages and disadvantages of each strategy and provides examples of how these strategies have been implemented successfully in the banking industry. Furthermore, the paper examines the role of regulatory authorities in overseeing credit risk management practices in financial institutions. It discusses the regulatory framework for credit risk management and highlights the importance of compliance with regulatory requirements in mitigating credit risk. Finally, the paper concludes with a discussion on the future of credit risk mitigation strategies in financial institutions. It emphasizes the need for continuous innovation and adaptation to new market conditions and regulatory requirements. The paper also stresses the importance of integrating credit risk management into overall risk management frameworks to ensure a comprehensive and effective approach to managing risk in financial institutions. Overall, this paper provides valuable insights into the importance of credit risk mitigation strategies in financial institutions and offers practical solutions for reducing exposure to credit risk. It serves as a useful resource for financial professionals, regulators, and policymakers seeking to enhance their understanding of credit risk management practices in the banking industry.

LONG-TERM LENDING FOR PUBLIC-PRIVATE PARTNERSHIP PROJECTS: OPPORTUNITIES AND PROSPECTS

The article is devoted to the topical issues of long-term lending to public-private partnership projects in the context of a permanent shortage of budget funds and the financial instability of business entities. The purpose of the study is to highlight the problems of attracting long-term credit resources by partners in the process of implementing joint projects and to outline areas for their solution. To achieve this goal, general scientific research methods and analytical data from the State Statistics Service of Ukraine and the National Bank of Ukraine were used.The article reveals the main problems in the development of the debt financial instruments market, which make partnership projects between the state and business unattractive for investors. It is argued that the possibility of providing long-term loans depends not only on the actions of the bank, but also on the monetary policy of the NBU, which should ensure the introduction of preferential reserve requirements for banks, the provision of irrevocable deposits, the NBU's approval to refinance banks for the implementation of PPP projects, and the introduction of preferential lending by banks to PPP projects. The authors emphasize the priority importance of the state policy on the development of programs for the availability of long-term loans in the process of implementing partnership projects. Given the underdevelopment of financial instruments for public-private partnerships, the author substantiates the need to use innovative instruments – credit derivatives, the effectiveness of which is confirmed by international experience. The article offers a list of the most effective financial instruments that should be used at each stage of the project life cycle.It is concluded that the recommendations provided will ensure that the partners attract the necessary amount of financial resources in the process of long-term project implementation and will allow them to obtain a synergistic effect from such cooperation.

Моделі ціноутворення кредитних деривативів

Derivatives play an important role in the processes that take place in the global economy and economic growth. They are critical for hedging risks in the banking sector, managing the interest rate in the activities of pension funds, satisfying insurance claims for insurers and other market participants, i. e. reducing uncertainty arising from fluctuations in prices, credit rates, currency fluctuations, interest rates, etc. Today, they are actively used in the world practice of all industry sectors. The aim of the article is to develop pricing models for credit derivatives, taking into account the relationship between credit derivatives (CD) and structured credit products (SCP), as well as on the basis of identifying differences in the results of credit correlation of defaults, analyzing the evolutionary and essential characteristics of the CD and SCP markets. The authors systematized and classified them; their structural characteristics are provided; the main trends characteristic of the CD and SCP markets in the context of the markets of traditional derivatives are studied; the method of their design with the help of clinical documentation is determined; the major aspects of their modeling and pricing are considered, also an own credit product is designed and the spread is calculated using the pricing model. The article considers the problem of choosing an approach for assessing and calculating the correlation of defaults, which is an integral part of the pricing models of credit derivatives. On the basis of the given methodology for designing the SCP with the help of CD and the key aspects of modeling and pricing of CD and SCP, a basket credit default swap was designed on the basis of three corporate names. The designed product meets all the basic requirements for standard basket products in terms of content. The calculations were made based on the use of two different copulas to assess the correlation of defaults. The results can be used to design and evaluate a derivative on the correlation risk of issuers.

CREDIT DERIVATIVE -An Alternative Tool for Indian Commercial Banks to Transfer Credit Risk

CREDIT DERIVATIVE -An Alternative Tool for Indian Commercial Banks to Transfer Credit Risk

Credit Derivatives : Main Concepts and Pricing

The investors have the possibility to structure and to optimize the risk adjusted performance of their liabilities by diversifying them among several markets and instruments. Credit derivatives are financial instruments which allow a restructuring of the risk/return profiles of credits and permit investors to access new markets. They facilitate the trading of credit risk, its transfer and hedging. They can reduce transaction costs and provide managers a way to "short sell" loans or bonds. They offer to investors the possibility to leverage bond or loan positions. These products complete also the market since they provide a mean to synthesize assets which are not available in the market. This paper surveys the main types of credit derivatives and their valuation. Forward contracts on bonds, Total Return Swaps, Credit Default Swaps, Basket Default Swaps, Credit Default Exchange Swaps, Credit Linked Notes, Basket Default Notes, Levered Portfolio Notes, and Credit Spread Derivatives are subsequently studied in terms of definition, overview, structure, benefits, and pricing.

Decision Analysis on Operation of Commercial Banks Based on the Application of Credit CDS

Affected by the new crown epidemic, it is difficult for Chinese small and medium-sized enterprises to ensure the normal operation of the industrial chain in terms of business operation and development, which may lead to the inability to repay their loans in commercial banks in time, triggering credit default incidents. CDS is a new credit derivative instrument, which can alleviate the default risk held by creditors to a certain extent and enhance the trust of both borrowers and lenders. This paper tries to apply the CDS mechanism to the Chinese market, using the TOPSIS model to score some companies, and explore what types of corporate loans commercial banks need to use CDS products for risk mitigation. It is found that enterprises with poor profitability, small development prospects, high credit risk and weak solvency need to pay special attention to bank loans.

The impact of COVID-19 on the relative market efficiency and forecasting ability of credit derivative and equity markets

While there has been a significant amount of research related to COVID-19’s impact on financial markets, none has addressed the potential change in relative market efficiency and associated forecasting power of credit and equity markets. Accordingly, we examine the impact of COVID-19 on previously observed predictive power of cross-market informational flow in the high yield CDS and equity markets. Our analysis reveals that, a significant structural break occurred with the onset of COVID-19 in which both markets exhibited flow patterns distinct from those observed in the past. This indicates that investors reacted to the pandemic and new information coming to market differently than in the past. Moreover, we empirically link the structural break to governmental measures enacted to stabilize financial markets and economies. Finally, we observe that the break was more severe in the equity than CDS market, a finding consistent with the CDS market having an overall informational advantage.

Sovereign credit default swaps: Managing risks when the fiscal house rumbles

This paper seeks to dissect risks which stem from the features of a sovereign credit default swap under the architecture of the 2014 ISDA Credit Derivatives Definitions (the 2014 Definitions). The paper begins with an overview of the market structure and functions of a sovereign credit default swap, followed by a brief discussion of the landscape behind the product. It then provides a narrative on specific risk considerations, mapped under broad themes such as the Credit Derivatives Physical Settlement Matrix (the Matrix) terms published by the International Swaps and Derivatives Association, Inc. ( ISDA) (including trigger obligations, deliverable obligations, credit events and settlement risk). Examples of Credit Derivatives Determinations Committee (DC) deliberations have been drawn in to elucidate aspects of how the product terms are applied in practice. The goal of the paper is to assist practitioners, infrastructure providers, risk managers, regulators, academics, sovereign issuers and creditors to identify risks and assess the efficiency of sovereign credit default swaps (SOVCDS) as a hedging tool. Due to the vastness of the subject, the paper focuses on SOVCDS traded as a `Standard` transaction type (TType) under the Matrix, where a DC credit event announcement crystallises settlement obligations.

Default Clustering Risk Premium and its Cross-Market Asset Pricing Implications

This study examines the market-implied premiums for bearing default clustering risk by analyzing credit derivatives contracts on the CDX North American Investment Grade (CDX.NA.IG) portfolio between September 2005 and March 2021. Our approach involves constructing a time series of reference tranche rates exclusively derived by single-name CDS spreads. The default clustering risk premium (DCRP) is captured by comparing the original and reference tranche spreads, with the former exceeding the latter when investors require greater compensation for correlated defaults at the portfolio level. The fitted DCRP level significantly increased in response to the 2007-9 global financial crisis and remained relatively stable for a period, followed by a gradual decline beginning in 2016. Notably, the COVID-19 shock caused another sharp rise in the DCRP level. Our empirical analysis finds that the estimated DCRP has significant implications for asset pricing, particularly in affecting the investment opportunities available to U.S. stock investors during times of instability in the financial system.

Indifference pricing of credit default swaps in a multi-period model

Credit default swaps (CDS) are the most common type of credit derivatives used for hedging and speculative purposes in credit markets. We consider a representative risk-averse investor who has initial endowment in credit instrument and invests in traditional financial instruments. Using the utility indifference pricing approach, we construct a pricing framework for single-name CDS contracts with periodic payments in a multi-period model. Moreover, we analyze CDS buyers with different trading motives, and examine the effect of risk aversion on the indifference upfront prices and credit spreads of CDS for investors with hedging or speculative motives. In particular, our results show that speculation in the CDS market provides a potential explanation for the formation of the negative CDS-bond bases during and after the global financial crisis.

Spectral Expansions for Credit Risk Modelling with Occupation Times

We study two credit risk models with occupation time and liquidation barriers: the structural model and the hybrid model with hazard rate. The defaults within the models are characterized in accordance with Chapter 7 (a liquidation process) and Chapter 11 (a reorganization process) of the U.S. Bankruptcy Code. The models assume that credit events trigger as soon as the occupation time (the cumulative time the firm’s value process spends below some threshold level) exceeds the grace period (time allowance). The hazard rate model extends the structural occupation time models and presumes that other random factors may also lead to credit events. Both approaches allow the firm to fulfill its obligations during the grace period. We derive new closed-from pricing formulas for credit derivatives containing the (risk-neutral) probability of defaults and credit default swap (CDS) spreads as special cases, which are derived analytically via a spectral expansion methodology. Our method works for any solvable diffusion, such as the geometric Brownian motion (GBM) and several state-dependent volatility processes, including the constant elasticity of variance (CEV) model. It allows us to write the pricing formulas explicitly as infinite series that converges rapidly. We then calibrate our models (assuming that GBM governs the firm’s value) to market CDS spreads from the Total Energy company. Our calibration results show that the computations are fast, and the fit is near-perfect.

Internet Searches, Household Sentiment, and Credit Spreads

We use Google internet search volumes to measure households’ pessimism about overall market-wide credit health in the economy and show that this “household default sentiment” is positively correlated with the credit default swap (CDS) spread level in the market. However, while household default sentiment might drive the cost of credit to some degree, either directly or indirectly through its effect on the stock market, we find the stock market’s opinion about the credit risk in the economy (default probabilities backed out from structural models) to be much more important in explaining credit spreads. The rather weak link between household sentiment and CDS spreads, meanwhile, is consistent with the almost complete absence of retail investors (households) in the institutional investor-dominated credit derivatives market. The results are essentially the same, whether we look at market-wide CDS indexes or single-name CDS contracts, and whether we exclude the financial crisis or not.

Copula sensitivity analysis for portfolio credit derivatives

Modeling dependence among input random variables is often critical for performance evaluation of stochastic systems, and copulas provide one approach to model such dependence. In the financial industry, the dependence among default times of different assets drives the pricing of portfolio credit derivatives, including basket default swaps and collateralized debt obligations. Copula sensitivities provide information about how changes in the dependence level affect the output. We study sensitivity analysis of elliptical copulas and Archimedean copulas using infinitesimal perturbation analysis, and an unbiased estimators is derived using conditional Monte Carlo (CMC) to address discontinuities that arise in portfolio credit derivatives. In simulation experiments, the new estimators have smaller variance than other applicable methods.

Credit default swaps (CDSs): an effective tool to manage credit risk of Indian banks

PurposeCredit default swaps (CDSs) are among the most widely used credit derivatives since their innovation and designed to hedge the credit risk of reference entities. They were exposed after the global financial crisis of 2007–08, and were blamed for its occurrence. This paper aims to describe the fundamental mechanism of CDSs, demonstrating how a CDSs contract works. Further, this study explores the growth of the global and Indian CDS market by taking a holistic perspective.Design/methodology/approachAn objective-driven descriptive research design is adopted to achieve a rigorous and accurate analysis of the study. Therefore, research papers from high-impact journals have been carefully reviewed to achieve the aim of the study.FindingsThe study shows that CDSs are still in their infancy in India. Banks are the primary market makers and users in the Indian CDSs market; therefore, regulatory authorities must assist them to boost the market. For banks to become more confident, they should gain experience and knowledge from other active CDSs markets around the world.Originality/valueThis study attempts to provide insights into the current state of the global as well as the Indian CDS market. Further, this study suggests approaches for the Indian banking sector to play an active role in the Indian CDSs market.

Geometry and Spectral Theory Applied to Credit Bubbles in Arbitrage Markets: The Geometric Arbitrage Approach to Credit Risk

We apply Geometric Arbitrage Theory (GAT) to obtain results in mathematical finance for credit markets, which do not need stochastic differential geometry in their formulation. The remarkable aspect of the GAT is the gauge symmetry, which can be translated to the financial context, by packaging all of the asset model information into a (stochastic) principal fiber bundle. We obtain closed-form equations involving default intensities and loss-given defaults characterizing the no-free-lunch-with-vanishing-risk condition for government and corporate bond markets while relying on the spread-term structure with default intensity and loss-given default. Moreover, we provide a sufficient condition equivalent to the Novikov condition implying the absence of arbitrage. Furthermore, the generic dynamics for an isolated credit market allowing for arbitrage possibilities (and minimizing the total quantity of potential arbitrage) are derived, and arbitrage credit bubbles for both base credit assets and credit derivatives are explicitly computed. The existence of an approximated risk-neutral measure allowing the definition of fundamental values for the assets is inferred through spectral theory. We show that instantaneous bond returns are serially uncorrelated and centered, that the expected value of credit bubbles remains constant for future times where no coupons are paid, and that the variance of the market portfolio nominals is concurrent with that of the corresponding bond deflators.

Credit Default Swaps

Credit default swaps (CDS) are the most common type of credit derivative. This paper provides a brief history of the CDS market and discusses its main characteristics. After describing the basic mechanics of a CDS, I present a simple valuation framework that focuses on the relationship between conditions in the cash and CDS markets as well as an approach to mark to market existing CDS positions. The discussion highlights how the 2008 global financial crisis helped shape current practices and conventions in the CDS market, including the widespread adoption of standardized coupons and upfront premiums and the increased reliance on centralized counterparties. I also address CDS indexes--focusing on their growing role as key indicators of investors’ attitudes toward credit risk--and briefly examine their behavior during periods of acute financial or economic dislocations, including those associated with the COVID-19 pandemic.