Sovereign risk has grown with the exposure of emerging markets. Country risk is somehow hybrid in nature. It can be an economic crisis, a currency crisis or a political crisis. Economic crises tend to increase the default rate of all private obligors residing in the country. Another aspect of country risk is inconvertibility risk.
Credit derivatives allow us to trade credit risk as a commodity, in isolation from the underlying assets, such as interest rate and foreign exchange risks. In addition, there was no way to hedge credit risk until the appearance of credit derivatives. The insurance function of instruments is not the unique key factor.
Hedging is the most direct application of credit derivatives for bankers looking to insure against excessive risks or aiming to reshape the risk of their portfolios.
Credit derivatives have an obvious potential for portfolio management because they are new tools helping to reshape the risk-return profile of portfolios without cash sales of assets or to extend exposure beyond limits by transferring excess risks to others. They also create an inter-bank market for credit risk, allowing banks to rebalance their specific portfolios […]
Tailoring and customizing exposures is a major function of credit derivatives. This helps to reshape individual and portfolio credit risk profiles so that they meet eligibility criteria, for both lenders and investors.
There is no need to stick to cash exposures with credit derivatives. By unbundling the credit risk component from the cash transactions, market players can create synthetic exposures that are not available in the cash market.
The rationale of securitizations is very simple. The first motivation is arbitraging the cost of funding in the market with funding on-balance sheet, for a bank or a corporate entity. The second motivation is off-loading credit risk to free capital for new operations or to modify the risk-return profile of the loan portfolio of banks.
The issue, when off-loading risks, is whether freeing up capital in this way is economically acceptable. The solution lies in finding out whether this makes the risk-return profile of the banking portfolio more efficient (higher return for the same risk or lower risk for the same return).
The analysis below uses an example. Its purpose is to determine the costs and benefits of the transaction and to assess the impact on return on capital. There are three steps: the description of the original situation before securitization; the calculation of the funding cost for the originating bank; the funding cost through securitization. The […]
In our example, the influence on the equity return results from both the lower level of equity and the reduced cost of funding through securitization. The gain value is either a present value or an improvement of yearly margins averaged over the life of the transaction. The capital saving is a preset forfeit percentage, used […]
