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marlie
02-22-2008, 02:49 PM
On the bottom of page 469. The net revenue for the high quality bank is 280,000. Anybody can tell me how to get the number?
I know on the footnote 40, it says (libor+50bp)*100-(libor-20bp)*98.4.
But first that doesn't give 280,000. second, where does this 98.4 come from?
Thanks in advance.

Laurelinda
02-22-2008, 04:02 PM
The Net capital charge for Bank A is 1.6%, which is where the 98.4 comes from: You have to pay funding cost (Libor-20bps) on all of the notional except the capital charge.

As for the rest of the formula, you're only missing the 50bps that get paid to Bank B for the credit swap.

(Libor+50bps)*100M-(50bps)*100M-(Libor-20bps)*98.4M
= Libor*100M-(Libor-20bps)*98.4M
= 5.2%*100M - 5%*98.4M
= 5.2M - 4.92M
= 280,000

marlie
02-22-2008, 05:33 PM
Thanks. but why in the first part, the funding cost is libor-20bp on 92% of norminal calculated as (L-20)*92, but in the second part it also says the funding cost libor-20bp on 92% of norminal, but this 92% is not used anywhere?

Laurelinda
02-22-2008, 09:05 PM
It confused me, too, at first and I'm not quite sure why they drew the diagram that way.

The Capital Charge is (Risk Weight x 8%). Lower quality Bank B still has the equivalent of a long position in the $100M loan, so they have a flat (100% x 8%) capital charge as in the first part--hence the 92--but they don't have to pay the funding cost, so I don't know why it's still pictured that way. :shrug:

marlie
02-25-2008, 12:23 PM
OK. I see. It is probably an error, like many other errors in the book. Thank.

Will Durant
02-25-2008, 05:03 PM
Great catch.

Bell
02-26-2008, 06:11 PM
LaureLinda;
what is going on here?? Im lost. could you explain please???

The Net capital charge for Bank A is 1.6%, which is where the 98.4 comes from: You have to pay funding cost (Libor-20bps) on all of the notional except the capital charge.

As for the rest of the formula, you're only missing the 50bps that get paid to Bank B for the credit swap.

(Libor+50bps)*100M-(50bps)*100M-(Libor-20bps)*98.4M
= Libor*100M-(Libor-20bps)*98.4M
= 5.2%*100M - 5%*98.4M
= 520,000 - 492,000
= 280,000

Laurelinda
02-27-2008, 12:27 AM
LaureLinda;
what is going on here?? Im lost. could you explain please???

I'll try if you tell me where you're getting lost! The point of the scenario on the bottom of p. 469 is to show that both banks can increase their return on capital by entering into the credit swap, rather than both investing directly in the loan.

You can increase (revenue)/(capital) either by increasing revenue or by decreasing capital. Bank A loses some revenue by paying Bank B 50 bps for the credit swap, but because it has reduced its capital charge more (1.6% rather than 8%), its return on capital increases. Bank B, on the other hand, has the equivalent default risk of a long position in the loan, so it has the standard 8% capital charge. However, it receives 50 bps while paying no funding cost (whereas it would receive Libor + 50 and pay Libor + 25 if it invested directly), so revenue is increased, and return on capital increases.

With me so far? Is it the calculations themselves that are tripping you up?

Bell
02-28-2008, 05:49 PM
[
With me so far? Is it the calculations themselves that are tripping you up?[/QUOTE]

Im gonna be disappointing. I havent really read that part yet. I started to but didnt find it interesting. Yet, I need to raise my interest of it. Maybe you can explain in "simple terms" what is the chapter about? That way, I guess goingback to it will make it easier and interesting. Kinda like what I did for the Credit risk models reading. Remenber?

Laurelinda
02-28-2008, 08:35 PM
Im gonna be disappointing. I havent really read that part yet. I started to but didnt find it interesting. Yet, I need to raise my interest of it. Maybe you can explain in "simple terms" what is the chapter about? That way, I guess goingback to it will make it easier and interesting. Kinda like what I did for the Credit risk models reading. Remenber?

Oh, I get it! You're lost in the whole long chapter. :) I know what that feels like. :tup:

Well, let's see if I can put together a user-friendly version...

Chapter 12 is about reducing, transferring or otherwise mitigating your credit risk exposure.

You can do it in three basic ways:

1.) Some kind of insurance against having to bear the full credit loss. This could be:
a.) Simple bond insurance or a letter of credit.
b.) Reserving the right (as an investor) to demand that the company pay you a certain amount for the rest of the bond before it's too late and they default. (This is called a put provision.)
c.) If I owe you $X and you owe me $Y, then if I default you don't still owe me $Y. You only owe me $Y-$X, if it's positive, so you're partly protected. (This is called netting.)
d.) If you and I are in a contract and your position declines in value, I pay you the difference at the end of each day instead of waiting until I have to pay it all at some later date. (This is called marking to market.)
e.) I can put up collateral so you get something concrete if I default.
f.) We can close out the contract early after I'm downgraded, instead of waiting until I default. (This is like the put provision in (b) except it's automatic and agreed upon when the contract is issued.)

2.) Buy derivatives that offset your losses. Everything mentioned in section 5 is a variation on a single theme: I pay you something we've agreed on. In return, if I lose money due to a credit loss, you pay me what I lost. It's like insurance in the form of a swap. I can elaborate later if you'd like me to go into particulars.

3.) Securitize your credit risk and sell it off to investors with a higher risk tolerance. For example, you can take a pool of loans and divide the incoming cash flow into three pieces, which you sell. One piece has to take all of the first X% of credit losses. One piece takes the next Y%. The last piece never suffers any credit losses until more than X%+Y% of the loans have defaulted.

Does that help? Want me to talk about the different kinds of credit swaps?

Bell
02-28-2008, 09:38 PM
http://www.actuarialoutpost.com/actuarial_discussion_forum/images/icons/icon14.gif
Thumbs up

Bingo. This is what Im talking about.

Are you a manual writter or an exam taker?? :viola:

I' want to hear about credit derivatives (credit swaps?).

thx./

Laurelinda
03-02-2008, 05:27 PM
Are you a manual writter or an exam taker??

:rimshot:

I' want to hear about credit derivatives (credit swaps?).

thx./

Sorry it's been so long, haven't been on the computer much. You've probably moved on from Crouhy a long time ago.

But just in case (and since it's good for my own memory to write it all out)...

The book talks about 5 types of credit derivatives:

1.) Credit Default Swaps (CDSs)
2.) Total Return Swaps (TRSs)
3.) Asset-Backed Credit-Linked Notes (CLNs)
4.) Spread Options
5.) Credit Intermediation Swaps

1.) Credit Default Swaps

This is the most basic kind. The credit protection buyer (I'll call him the PB for fun) pays the credit protection seller (the PS) x bps per year times some notional amount. In return, if a credit event occurs (which could be default, bankruptcy, downgrade, or just a large fall in underlying asset price), the PS pays the PB some amount that compensates for the loss.

This payment could be a flat, predetermined amount, or it could be the difference between between par and the post-credit-event market value of the asset. (The second is the most common.) The PS could pay the whole par amount and receive a physical transfer of the asset itself, which would leave both the PS and the PB in the same net position as if he'd only paid (par - market value).

Example:

Notional amount: $400M
CDS premium: 5 bps
Market Value after credit event: $160M

The PB pays the PS ($400M x 50 bps) = $200,000 a year.
If and when the credit even occurs, the PS pays the PB ($400M - $160M) = $240M, so the PB owns the whole $400M again: $240M in cash + an asset worth $160M.

2.) Total Return Swaps

CDSs are really for people who want to get rid of credit risk. TRSs are for people who want to assume credit risk for the sake of the extra return. Now the protection buyer becomes a risk seller (RS) and the protection seller becomes a risk buyer (RB).

The RS periodically pays the RB an amount equivalent to the total return on the underlying asset, in return for some stipulated payment, such as LIBOR + X bps. Basically the RB has a synthetic long position in the asset: It's as if they own it, but it isn't on their balance sheet.

Example:

Underlying asset: $10M loan
RS's required funding rate in order to purchase the loan: LIBOR
TRS premium: LIBOR + 50 bps

The RB pays the RS (LIBOR + 50 bps) for the swap. The RS funds the loan with LIBOR, making a 50 bp profit. The RS receives the periodic coupons + price appreciation (or minus price depreciation) from the loan, and passes it on to the RB.

3.) Credit-Linked Notes

This is basically a bond whose coupons and redemption amount are tied to the performance of a loan. Usually the most the investor can lose is their initial investment, and the bank absorbs the remainder of the losses.

4.) Spread Options

This is an option on credit spreads...wow, bet you could have guessed!

Payoff = Max(0, spread at maturity - strike) x Modified Duration X Notional

Example:

Strike spread for Asset A = 125 bps
Modified Duration = 5
Notional = $10M

Scenario 1: Spread at maturity is 100 bps. Payoff = 0.
Scenario 1: Spread at maturity is 150 bps.
Payoff = (0.015-0.0125) x 5 x $10M = $125,000

5.) Credit Intermediation Swaps

A highly rated third party (AAA) stands between two entities that want to swap with each other but don't like each other's credit ratings. The third party receives a premium and absorbs any credit losses.

Example:

A and B want to enter a fixed-for-floating swap but want Bank X to take on all the credit risk for the transaction.

A pays Bank X 7%. Bank X passes the 7% on to B. B pays Bank X (LIBOR + 5 bps), and Bank X passes (LIBOR - 10 bps) on to A.

Now A has a floating-for-fixed swap, B has a fixed-for-floating swap, and Bank X gets 15 bps every time, without any exposure to the interest rate risk of the swap, but with all of the credit exposure.

Enjoy!

Bell
03-02-2008, 08:42 PM
MarieLaure:

thanks for this complete, yet concret account of credit derivatives. Some of which I was already familiar with, as you might have guessed.

what credit risk models (among the ones discussed in the book) is (are) appropriate for pricing CDSs?

What default correlation models are used in the CDS market?

Try those, and I will gladly share my answers too.

is there anything out of that chapter I shall know? Because I tell you, Im getting sick of the Crouhy book.

Once again, thanks for the time and effort.

Laurelinda
03-05-2008, 12:32 PM
what credit risk models (among the ones discussed in the book) is (are) appropriate for pricing CDSs?

What default correlation models are used in the CDS market?

Try those, and I will gladly share my answers too.


Hi Bell, I gave Crouhy a break for a while. I have no answer to those questions, but I'd love to hear your answers.

From the chapter we've been discussing, I think I posted something about everything that is essential. Except for one extra concept (the one pertaining to the problem that started this thread): Sometimes regulations allow companies to save money on capital and improve returns by entering into credit derivatives, while other derivatives, although they reduce your risk, current require an extra capital charge. In other words, adding regulatory capital into the mix makes things funky.