Credit Products and Derivatives

This is a 3-day course covering corporate bonds and credit derivatives, from plain vanilla credit default swaps (single names and index) through to structured credit derivatives involving correlation products such as nth to default baskets, index tranches, synthetic collateralized debt obligations and more.

The programme explores each product holistically, covering product mechanics and trading conventions, pricing, applications in investing and trading strategies including pitfalls to be aware of, risk management, infrastructure requirements and regulatory capital for banks.

Practical application is emphasized throughout the programme via real-world case studies and workshops, which focus on international best practices and explore the experiences of a range of institutions.

The course caters for participants at all experience levels, from beginner, through intermediate to advanced.

The course is targeted at the full range of participants in the credit derivatives market, both on the buy side and sell side:

• Credit traders and salespeople
• Structurers
• Asset managers
• ALM and treasury (Banks and Insurance Companies)
• Loan portfolio managers
• Product control, finance and internal audit
• Risk managers and risk controllers

• Gain familiarity with credit market infrastructure and credit products such as Credit Default Swaps, Index CDS & Options and Structured Credit Derivatives
• Learn how to express credit views, take and manage credit risk
• Learn how to structure, and manage the risks of, different types of Structured Credit Products including CLN’s, Quanto CDS and Tranched Products

It is assumed that participants have a basic understanding of Fixed Income markets and Derivative instruments: forwards, call and put options.

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 

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

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