We consider a two-segment portfolio, with two exposures: A is an existing exposure, and B is a new exposure of varying size. We examine what happens in terms of return on economic capital when the additional B exposure increases, while its AIS in percentage or, equivalently, its Return on Assets (ROA) remains constant.
Various sensitivity analyses apply to portfolios. To proceed on an orderly basis, we need to refer to a unique base case, and change only one variable at a time. For instance, we can change As exposure from 100 to 110, then revert to the 100 value for A and change Bs exposure from 50 to […]
Enhancing the risk-return profile of the portfolio can minimize risk given return, increase return at constant risk, or improve both if the portfolio structure is inefficient. In addition, when removing funding constraints, it is no longer necessary to trade-off risks and return within the portfolio by changing the exposures. It becomes necessary to decide along […]
This section provides a broad overview of credit derivatives, what functions they fulfill, who has an interest in them and why. Functions of Credit Derivatives Credit derivatives are instruments serving to trade credit risk by isolating the credit risk from the underlying transactions.
The main specifics of credit derivatives are: • The underlying assets. • The payment terms. • The value of payments under a credit event. • The conditions defining a credit event.
These include credit default swaps, credit default options or indemnity agreements. Conceptually, they are insurance products. The protection buyer looks for insurance in the event of default of the underlying. The seller requires a premium, and/or a periodic fee, for this service.
A total return swap exchanges the total return, current yield plus any change in value, whether positive or negative, between two assets. The exchange of cash flows occurs whether or not there is a default event. The swap exchanges flows and capital gains or losses periodically or at some fixed dates. Usually, periodic flows are […]
Credit spread derivatives refer to the credit spread relative to the risk-free benchmark or differentials of credit spreads of two risky assets. In addition, there are credit spread forwards and credit spread options. The specifics of credit spread derivatives is that they isolate the effect of spreads as opposed to contracts on prices subject to […]
Basket swaps refer to portfolios of asset defaults rather than single asset credit events. The main characteristic of a basket credit derivative relates to the first-to-default concept.
A Credit-Linked Note (CLN) is like a credit derivative. It is a debt with payments linked to the performance of assets. Notes are tradable in the market. Being liquid is a major benefit. Protection buyers dislike looking for investors directly. They prefer to have something traded. CLNs meet this requirement. In order to be tradable, […]
