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Introduction to Derivative Instruments – Part 2

Link’n Learn

Leading Business Advisors

Contacts

Guillaume Ledure-ManagerAdvisory and ConsultingLuxembourgEmail: [email protected]: 00 352 45145 4701

Elaine Canty - ManagerFinancial AdvisoryIrelandEmail: [email protected]: 00 353 417 2991

Fabian De Keyn–Senior ManagerCapital MarketsLuxembourgEmail: [email protected]: 00 352 45145 3413

3 Link’n Learn – Introduction to Derivative Instruments – Part 2 © 2015 Deloitte

Preface

This presentation (along with Webinar Link 'n Learn: Introduction to Derivatives Instruments Part 1) is designed to give an introductory overview of the characteristics of some of the more prevalent derivatives along with addressing some topical issues currently faced when valuing these instruments.

Further learning references regarding valuation and analysis of these instruments will be provided at the end of this webinar.

Agenda

2. Credit-Linked Notes

1. Introduction

3. Regulatory Context

4. Recent Trends in Derivatives Valuation

4.1. OIS Discounting

4.2. Credit Valuation Adjustment

5. Illustration: Swap Trading in the Past and Nowadays


1. Introduction


Reminder• Recall from our first presentation that a derivative is a financial instrument whose value

changes in response to changes in the value/level of an underlying variable.

• Its value is derived from the value of the underlying. For example:

Interest rate swap – value is derived from current spot and forward interest rates

Commodity forward – value is derived from the spot value of the commodity

Equity option – value is derived from the spot value of the equity

• There is either no initial net investment (e.g. interest rate swap) or an initial net investment that is smaller than would be required for other contracts with similar responses to market movements (e.g. an equity option)

• It is settled at a future date or series of future dates.

• Derivatives introduced in part 1: futures, forwards, IRS, CCIRS, CFD, options, TRS, etc.


Use of Derivatives

Usual practice is to acquire leverage by investing using borrowed assets

Leverage through derivatives is obtained by getting market exposure with no or limited initial investment

Uses of derivatives

Derivatives, whatever their kind, might be used for several purposes:

• Hedging

• Speculation

• Arbitrage

They offer risk-return balance and are dedicated to transfer risk from a risk-averse party to a risk-taker party

Hedging

Derivatives contracts are used to reduce the market risk on a specific exposure

Arbitrage

Derivative contracts are used to offset positions in several instruments to locka profit without taking risk

Speculation

Derivatives contracts are used to bet on a specific market direction

They provide more leverage than a direct investment in the related underlying

Financial markets gather so many participants that it is always possible to find someone willing to take the opposite position to yours


Use of Derivatives - Examples

A Hedging Use an IRS to hedge an interest rate exposure

B Speculation Use an option to gain leveraged equity exposure

C Arbitrage Buy commodity forward for EUR 100 in one

market / sell same for EUR 150 in another market


Leverage – Example

XYZ shares currently trade at EUR 100. We believe these shares will perform well in the coming year.

Choice?

Or

Invest EUR 100k directly in XYZ shares (i.e. buy 1,000 shares)

2. Invest EUR 100k in call options at strike EUR 110, expiring at year end. These options cost EUR 5 per option where each option gives the holder exposure to 1 share of the underlying equity.. Therefore, we have purchased the option to buy 20,000 shares at EUR 110 per share, at expiry.

1

2



1. XYZ shares trade at EUR 120

We have seen a 20% growth in our initial investment. It is now worth EUR 120k = 100k * (120/100)

We have seen a 100% growth in our initial investment of EUR 100k. We will realise EUR 200k if we exercise the option= 20,000 * max (120-110, 0)

Let’s Look at Two Outcomes at Year End

1

2



2. XYZ shares trade at EUR 90

We have seen a 10% loss on our initial investment. It is now worth EUR 90k = 100k * (90/100)

We have seen a 100% loss on our initial investment of EUR 100k. The option are worthless= 20,000 * max (90 -110, 0)

Let’s Look at Two Outcomes at Year End

1

2


Effective Tools to Manipulate CarefullyDerivatives Failures

Derivatives can be highly profitable because of the direct profit they generate or by the potential losses they contribute to erase

The reality is probably more like…Despite this, their public image nowadays is like…


2. Credit-Linked Notes


Definition

Let's suppose a trust issues medium term notes and wants to structure a CLN. How is it put together? Typically the trust would select a reference entity and would then sell protection using a credit default swap (CDS) on that selected reference entity. Selling protection would mean the trust received a regular fixed payment from the CDS counterparty (dealer). The following example assumes that the CDS is physically settled.

Example

A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors.

It is issued by a special purpose company or trust, designed to offer investors par value at maturity unless the referenced entity defaults in which case the investors receive a recovery rate. The trust will also have entered into a credit default swap with a dealer. In case of default, the trust will pay the dealer par minus the recovery rate, in exchange for an annual fee which is passed on to the investors in the form of a higher yield on their note.

The purpose of the arrangement is to pass the risk of specific default onto investors willing to bear that risk in return for the higher yield it makes available.

Definition


Definition

The trust now issues the CLN. The CLN would be for the same principal amount and maturity as the CDS. The final terms of the CLN would mirror the terms in the CDS transaction.

The CLN investor would pay cash to the trust to buy the CLN. The trust would pay the investor regular interest until the maturity of the note.

TrustCLN Investor Dealer

Coupons

PrincipalCDS spread

Provided there is no credit event by the reference entity the investor receives back the principal investment on the maturity of the note

TrustCLN Investor Dealer

Principal Trade matures

What happens if the reference entity experiences a credit event?


Definition

The CLN investor will experience a credit loss, this is what happens:

1. The CDS on which the trust sold protection is triggered. The trust pays to the CDS counterparty the principal amount of the CDS in cash. The trust receives in return a deliverable instrument normally a bond that was issued by the reference entity that is now in default.

2. The CLN is also triggered. The investor does not get his principal returned, instead the trust delivers the deliverable bond to the CLN investor.

The investor will have experienced a loss as a result of the credit event because the delivered bond will be worth less than the original sum invested. The scale of the loss incurred will depend on the market value of the delivered bond.

TrustCLN Investor

DealerDeliverable bond

Deliverable bond

Principal


Motivation

• The investor has the credit risk on the reference entity as well as the CLN issuer and therefore obtains a higher return on the CLN than would have been achieved on a normal medium term note.

• This means that different CLNs can be issued that exactly fit the investor's criteria including return, rating, maturity and amount. It can also mean that investors who are restricted from using credit derivatives because of operational, legal or regulatory constraints can still create the investments they want.

• Furthermore some investors are "real" investors - they have cash and need to use it. CLNs are cash based investments and meet these investor's requirements.

Why investors purchase CLNs?

• The issuer receives cash from the sale of the CLN. This has two advantages: First it can mean that the cost of funding for the issuer can be at or below the target cost of

funding. Second because the issuer has cash it means that the embedded CDS is effectively 100%

cash collateralised, (remember that the issuer is selling protection to the market place but buying protection from the investor). If there is a credit event the issuer is in control of the cash and is not dependent on the performance of the investor, (as it would normally be the case with a CDS).

Why issuers sell CLNs?


3. Regulatory Context


A Concern for all Market StakeholdersRegulatory Context

IFRS13EU Commission

Regulation 1255/2012

Fair value of assets or liabilities is defined as

the price that would take place in the market to

exit the position

CAPITAL REQ.EU regulation 575/2013

(a.k.a. “CRR”)Directive 2013/36/EU

(a.k.a. “CRD IV”)

Institutions shall establish and maintain systems and controls sufficient to provide

prudent and reliable valuation estimates

AIFMEU Directive 2011/61/EU

(a.k.a. “AIFMD”)

Managers are responsible for the

valuation of OTC derivatives and must

ensure their independent valuation

UCITSEU Directive 2009/65/EC

(a.k.a. “UCITS IV”)

Managers must ensure consistent and

independent valuationof OTC derivatives

EMIREU Commission

Delegated Regulation 648/2012

For OTC derivatives not centrally-cleared,

counterparties must put in place risk mitigation techniques and proper

procedures for collateral

management, including a daily Mark-

to-Market

Funds Industry

Banking Industry

Corporate Companies


UCITSRegulatory Context

• Undertakings for Collective Investment in Transferable Securities -collective investment schemes established and authorised under a harmonised EU legal framework

• UCITS established and authorised in one EU member state can be sold cross border into other EU member states

• “European passport” – no requirement for additional authorisation

• Designed principally for the retail market as open-ended diversified, liquid products

• These funds can be marketed within all EU countries, provided that the fund and fund managers are registered within the domestic country

• UCITS are permitted to use financial derivative instruments (FDI) as part of their general investment policies as well as for hedging

• The measurement and monitoring of all exposures relating to the use of FDI must be performed on at least a daily basis


European Market Infrastructure RegulationRegulatory Context

EMIR is specifically dedicated to the regulation of derivatives markets in Europe, with a two-fold objective• Regulate derivatives markets to increase transparency • Reduce counterparty credit risk

Three main impacts on derivatives markets

All standardized

OTC derivatives

must be cleared

through central counterparties

(CCPs)

Harmonized framework for the provision

of clearing services within

Europe

Clearing (Standardized)

All OTC and exchange-

traded derivatives

must be reported to

Trade Repositories

(TRs)

Reporting (All)

Non-cleared derivatives

must be subject to

strengthened risk

management requirements

Risk mitigation (Non-standard)


European Market Infrastructure Regulation (EMIR)Regulatory Context

• Designed to increase the stability and transparency of the OTC derivative markets throughout the EU

• All standardised OTC derivative contracts traded on exchanges and cleared through central counterparties

• Common rules for central counterparties (CCPs)

• Reported to trade repositories

• Non-centrally cleared contracts – higher capital requirements

• Measures designed to reduce counterparty credit risk for bilaterally cleared OTC derivatives

• Rules on the establishment of interoperability between CCPs


4. Recent Trends in Derivatives Markets

4.1. OIS Discounting

4.2. Credit Valuation Adjustment


Recent Trends in Derivatives Markets

DERIVATIVES (SWAPS) VALUATION

COUNTERPARTY CREDIT RISKTRANSPARENCY

Summary


Counterparty Credit RiskRecent Trends in Derivatives Markets

• Counterparty credit risk is the risk that an entity with whom one has entered into a financial contract (the counterparty) will fail to fulfil their side of the contractual agreement

• Counterparty risk is typically defined as arising from two broad classes of financial products:

1. Securities financing transactions e.g. repos and reverse repos and securities borrowing and lending

2. OTC derivatives including interest rate swaps, FX forwards and credit default swaps

Most significant class due to the size and diversity of the OTC derivatives market

• How to deal with counterparty credit risk when valuing derivatives?

1. Require the party with a negative MtM to post collateral in guarantee in case it goes into default

2. Adjust the valuation to incorporate credit exposure

• Collateral management can be practically burdensome and introduce operational risk


Swap Valuation: Reminders and FurtherRecent Trends in Derivatives Markets

• The fair value of an IRS, FX swap or forward at inception is usually zero

• Once the swap is struck, its market value will evolve and soon no longer be zero because of several effects:

− Interest rates will change over time

− Implicit forward rates will change over time

− Counterparty risk may change

…

…

Rec. Fix

Pay LIBOR

Rec. Notional(if cross-currency)

Pay Notional(if cross-currency)

Start Maturity

Valuation by discounting the future cash flows

Valuation of an Interest Rate Swap

etc.

• Valuation is performed under the Discounted Cash Flows Method:

− Liquid swaps with known market prices are used to build yield curves, themselves used for pricing other swaps

− Estimation of future (fixed or floating) cash flows

Forecasting future floating cash flows requires a yield curve calibrated on instruments of corresponding tenor

− Discounting of the future cash flows

Discounting is computed using a yield curve denoting the counterparty credit risk of the cash flows


Before the Credit CrisisRecent Trends in Derivatives Markets

• Before the onset of the credit-crisis in 2007:

− LIBOR, the short-term borrowing rate of AA-rated banks was seen as a proxy for the risk-free rate

− Counterparty credit risk was a minor concern and collateral agreements were far from systematic

− Yield curves calibrated on instruments of any tenor were basically identical

• Consequences on swap valuation:

− A yield curve calibrated on the market prices of the most usual liquid swaps (e.g. 6M in EUR, 3M in USD) was used to forecast floating cash flows

− This same curve was used to discount cash flows when the swap was collateralized or when the counterparty was “sufficiently solid” (i.e. well-rated)

Before the credit crisis, valuation was performed in a “Single-Curve Framework”


During the Credit CrisisRecent Trends in Derivatives Markets

• The onset of the credit crisis (esp. the collapse of Lehman Brothers) raised questions about the liquidity and creditworthiness of big banks, even well-rated:

− Regulators and public opinion called for increased transparency and regulation of OTC markets

− Collateralization with daily margin calls became a necessity

• A strong criticism of LIBOR as fair and risk-free reference rate arose

− Suspected manipulations of the LIBOR fixing procedures led to a distrust of LIBOR

− LIBOR, the rate of unsecured borrowing, denoted the risk of a AA-rated bank, but no more the absenceof counterparty credit risk

− LIBOR6M was riskier than LIBOR3M, itself riskier than LIBOR1M, etc.

• Central banks continued to provide abundant liquidity via their bank lending windows:

− Fed Funds (“cash”) and short dated T-Bills were the sole remaining assets considered as ± free of credit risk, since dealt with highest-quality government entities and for the shortest maturity (1 day)

− These short dated “risk free” assets were the only acceptable deliverable assets for collateralmaintenance


Consequences of the Credit CrisisRecent Trends in Derivatives Markets

• Behaviours of dealers on swap markets changed dramatically:

− Apparition of non-negligible tenor basis

− Large differences between yield curves calibrated on instruments of different tenors

• Consequences on swap valuation:

− Forecasting floating cash flows requires the use of the yield curve calibrated on instruments of the corresponding tenor

− Discounting cash flows of collateralized swaps requires the use of a “risk-free” yield curve

Best proxy: a curve calibrated on instruments with a 1D tenor (i.e. “Overnight-Indexed Swaps”)

3M EUR LIBOR-OIS spreadClose to 0 until credit crisis

Sub-prime crisis(2007-2010)

Euro sovereigndebt crisis (2011-2012)

StartMid-2007

Since the crisis, valuation is performed in a “Multi-Curve Framework”, with discounting under the OIS curve, considered as the sole “risk-free” curve


OIS Discounting and Multi-Curve FrameworkRecent Trends in Derivatives Markets

• An Overnight Indexed Swap is a fixed/floating IRS where the floating rate is calculated using the daily compounded overnight rate index

− Effective federal funds rate in USD, Euro Overnight Index Average (EONIA) in EUR, Sterling Overnight Index Average (SONIA) in GBP, etc.

− Forecasting the floating rate of a non-liquid OIS requires a curve calibrated on a 1D tenor (i.e. liquid OISs)

− Discounting collateralized cash flows requires the risk-free curve, i.e. the curve calibrated on liquid OISs

• For collateralized regular IRSs (say for instance 1Y fixed vs. 6M floating), two curves are necessary:

− The OIS curve calibrated beforehand as above to discount the cash flows

− The “LIBOR6M curve”, i.e. a curve calibrated using liquid swaps indexed on LIBOR6M

An Overnight-Indexed Swap can be valued under a Single-Curve framework This enables to calibrate this OIS curve using liquid OISs

Regular IRSs need to be valued under a “Dual-Curve framework” with OIS discounting The multiplicity of tenors (1D, 1M, 3M, 6M) results in the “Multi-Curve framework”

Valuation results may be very different than in the pre-crisis “Single-Curve” world


Issues of the Multi-Curve FrameworkRecent Trends in Derivatives Markets

1. Reporting issues:

‒ The transition from LIBOR to OIS curves may cause larger portfolio MTM changes resulting in greater income statement volatility

‒ Hedge accounting: hedge may prove less effective (or fail hedge effectiveness test) if e.g. hedge is discounted at OIS while the hedged item is not

2. Practical valuation issues:

‒ Active OIS markets do no exist for all currencies and may be limited to short to medium-term maturities (which makes it difficult to calibrate a complete discounting yield curve)

‒ Calibration of all yield curves should be a fully integrated process, since swaps used as calibration instruments have influence of several curves, especially when dealing with cross-currency swaps

3. Open debate: how to discount uncollateralized trades?

‒ Discounting using a LIBOR yield curve (represents a standard AA-rated banking counterparty)?

‒ Discounting using the OIS yield curve shifted by some credit spread (depending on the counterparty)?

‒ Discounting using the OIS yield curve and account for valuation adjustments?

No market consensus so far


Recent Trends in Derivatives MarketsSummary

DERIVATIVES (SWAPS) VALUATIONIncorporation of new market realities into pricing

Multi-curve framework (depending on collateralization)

COUNTERPARTY CREDIT RISKImportance of proper collateral management

Inclusion of Credit Support Annexes (CSA) in swap contracts

Inclusion of proper valuation adjustments

TRANSPARENCYEssential to know precisely the exposures of the bank with respect to each individual counterparty

High standards of transparency to guarantee investors protection and best execution within MiFID VALUATION ADJUSTMENTS

CVA (Credit) accounts for the counterparty credit risk if no collateral

DVA (Debit) accounts for own counterparty credit risk if no collateral


Sub-prime crisis

(2007-2010)Euro sovereign

debt crisis (2011-2012)

StartMid-2007

Since the crisis, rate ofcollateralized Overnight-Indexed Swap is seen as the true risk-free rate instead of LIBOR

The yield curve built upon OIS is the new standard for discounting

Challenges of collateral include the operational costs, the complex management of threshold and netting agreements, the determination of cheapest-to-deliver assets, etc.


Quantification of Credit RiskCredit Valuation Adjustment

• Traditional management methods of counterparty risk tend to work in a binary fashion:

− For example the use of a credit limit – if the limit is breached, financial institution would refuse to enter into a transaction

− Problem with this is that only the risk of a new transaction is being considered – but potential profit of the new transaction should also be a factor in the decision making process.

• By pricing counterparty risk, one can move beyond a binary decision making process:

− The question of whether to enter a transaction becomes simply whether or not it is profitable once the counterparty risk component has been priced in

− In other words we adopt the following equation:

Risky price = Risk-free price + CVA

Price assuming no counterparty risk

“Credit Valuation Adjustment” = Price of

counterparty risk


Quantification of Credit RiskCredit Valuation Adjustment

• The CVA “charge” needs to be calculated in a sophisticated way, basically as follows:

CVA = Present Value[Loss in case of counterparty default × Probability of default]

= (1-Recovery rate) × Exposure at default × Probability of default × Discount Factor

• The computation of CVA requires the following information

− The transaction in question i.e. is it an interest rate swap or an FX forward

− Whether there are other offsetting positions with the counterparty that will result in a netting effect (and is there a netting agreement for this to apply)

− Whether of not the transaction is collateralised

− Any hedging aspects of the underlying transaction

• The decision by an institution to enter into a transaction can now include whether or not the profit from the transaction more than covers the CVA “charge”

• Debit Valuation Adjustment (“DVA”) is a similar (positive) add-on used to account for the entity’s own credit risk


ChallengesCredit Valuation Adjustment

• While CVA valuation methodologies are well advanced, they are still not standardised:

− Can range from relatively simple to highly complex methods

− Methodology used largely driven by sophistication and resources available to market participant

− Depending on a particular participant, CVA can be quite large

• Common challenge for all entities computing CVA is obtaining the necessary market data:

− Requires some degree of judgement in coming up with proxy data in order to compute CVA

− Whether or not credit spreads are available

• Regardless of methodology used to compute CVA, a certain level of expertise and management judgment is required to ensure that CVA has been considered and appropriately applied


Recent Trends in Derivatives MarketsSummary

DERIVATIVES (SWAPS) VALUATIONIncorporation of new market realities into pricing

Multi-curve framework (depending on collateralization)

COUNTERPARTY CREDIT RISKImportance of proper collateral management

Inclusion of Credit Support Annexes (CSA) in swap contracts

Inclusion of proper valuation adjustments

TRANSPARENCYEssential to know precisely the exposures of the bank with respect to each individual counterparty

High standards of transparency to guarantee investors protection and best execution within MiFID

VALUATION ADJUSTMENTSCVA (Credit) accounts for the counterparty credit risk if no collateral

DVA (Debit) accounts for own counterparty credit risk if no collateral


Sub-prime crisis

(2007-2010)Euro sovereign

debt crisis (2011-2012)

StartMid-2007

Since the crisis, rate ofcollateralized Overnight-Indexed Swap is seen as the true risk-free rate instead of LIBOR

The yield curve built upon OIS is the new standard for discounting

Challenges of collateral include the operational costs, the complex management of threshold and netting agreements, the determination of cheapest-to-deliver assets, etc.


5. Illustration: Swap Trading in the Past and Nowadays


Cross-Currency SwapIllustration: Swap Trading in the Past and Nowadays

Before the 2007 crisis…

Classical valuation frameworkTwo yield curves are required:- 1 single “standard” curve for forecast

and discount in ccy1- 1 single “standard” curve for forecast

and discount in ccy2

… and after the crisisMulti-curve valuation frameworkFour yield curves are required:• 1 forecast curve in ccy1 corresponding to the right

LIBOR tenor• 1 discount curve in ccy1:

- OIS if collateralized- Standard Libor curve otherwise

• 1 forecast curve in ccy2 corresponding to the right LIBOR tenor

• 1 discount curve in ccy1:- OIS if collateralized- Standard LIBOR curve otherwise- Cross-currency and maybe tenor basis adjustments

Ccy1 is the collateral currency, ccy2 is the other one!

Regulatory and practical obligations• Report to a trade repository (EMIR)• Ensure there is a Credit Support Annex for

collateral definition and practical details• Fulfil MiFID transparency obligations• Collateral management: operations, netting

agreement, thresholds, etc.• If not collateralized trade:

- Compute CVA/DVA- Take netting into account- Consider other trades in portfolio


Useful references

Option, Futures and Other Derivatives, John C. Hull

Paul Wilmott on Quantitative Finance, Paul Wilmott

Credit Derivatives: Trading, Investing and Risk Management, Geoff Chaplin

Counterparty Credit Risk and Credit Valuation Adjustment, Jon Gregory

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This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, Deloitte Global Services Limited, Deloitte Global Services Holdings Limited, the Deloitte Touche Tohmatsu Verein, any of their member firms, or any of the foregoing’s affiliates (collectively the “Deloitte Network”) are, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your finances or your business. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication.

© 2015 Deloitte & Touche. All rights reserved

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