A credit event triggers the termination of the contract and a capital payment. Typical credit events include bankruptcy, failure to pay, or restructuring of outstanding debt. In the context of credit derivatives, the term ‘default’ is often used to mean ‘credit event’ (in contrast, ‘default’ for bond assets typically only means failure to pay).
When a credit event occurs, the seller of protection pays either:
■ physical settlement: USD 10m in return for USD 10m notional of Ford Motor Credit debt; or
■ cash settlement: a net sum representing USD 10m less the value of Ford Motor Credit debt in the marketplace.
In summary, a CDS is an insurance policy. Generally the purchaser of insurance pays a sum of money at regular periods and these payments are known as premiums.
The seller (or writer) of a CDS will only pay out in the event of a default which is determined by a legally defined event or events. Once default has been triggered the whole trade ceases and no more premiums are paid. That is why only the first premium is shown as a solid line in Figure 3.14 because it is bound to occur, while the others are depicted as dotted lines.
Figure 3.14 Cashflows on CDS
The amount and time of payment are impossible to know at the start of the trade hence the striped rectangle of possible times and amounts. Here we are showing a CDS which pays in cash.
3.11 Summary
Financial products differ from asset classes. A good way of understanding how a financial product works is by examining its cashflows.
Some trades have fixed dates and amounts, some have fixed dates and variable amounts, whilst others have one fixed starting cashflow but the others are unknown at time of trade. Many trades have no guarantee of receiving any cash or physical return for the purchase price. Both counterparties to a financial trade will understand the composite cashflows and enter into the trade if these cashflows accomplish what they wish to achieve.
Chapter 4
Asset Classes
In the previous chapter we described some common financial products. These products all have an underlying entity upon which the trade is based. These entities are generally grouped into common sets known as asset classes.
Traders are normally organised into desks, each desk trading the same class of assets. Processes that flow from these trades are also divided by their asset class.
Large parts of the trade lifecycle are generic: trades are executed, booked, confirmed and settled. But the actual implementation of these processes may vary from one class of assets to another. Here we discuss some common asset classes, their particular features and how they affect the trade processes. This chapter makes reference to products described in the previous chapter but there the emphasis was on comparing trades by looking at their cashflows whereas here we see other aspects of the trades and how they fit into their asset class.
4.1 Interest rates
Interest rates are based around the lending and borrowing of money in a particular currency.
The underlying market force affecting the pricing of interest rate products is the interest rate in that currency hence the name of the asset class.
Money can be borrowed for different periods of time (known as term) and the major set of financial products in interest rates are divided into three terms
■ short term (less than one year) are known as cash or money market trades
■ medium term (usually from one to two years) are futures
■ longer term (two or more years) are swaps.
Interest is paid to attract lenders to part with money which they could otherwise have used for purchasing other assets or kept for security. A person making a loan to someone else will therefore charge interest to compensate for the loss of opportunity to use his own money and because there is a reduction in his liquidity meaning that he has less ability to cope with sudden demands on his money such as to pay wages or fix broken machinery.
The result of charging interest when money is loaned causes an effect known as the ‘the time value of money’. In essence this effect means that money in the future is worth less than money now. This is not to be confused with inflation which is caused by price rises. (The two are similar and are correlated to each other but here we confine the discussion to interest rates.)
In mathematical terms,
So if I have 100 pounds and the interest rate is 5 % per annum then, in one year, my 100 pounds will be worth
So if I am expecting 100 pounds in one year with 5 % interest per annum then my present value of that future 100 pounds is
So we see that money is worth less over time. How much less depends on two facts.
■ prevailing interest rates – the higher the rate, the less money is worth
■ time – the longer the time period, the less money is worth.
Management of cash is vital to any organisation; too much cash is an under-utilisation of the organisation's assets, too little cash increases costs (due to having to borrow more money) and increases risk.
Since different organisations have continuously changing cash requirements there is a very active market in trading cash products. These products come into the asset class of interest rates.
We can divide the market on interest rate products into three groups of participants:
■ Central Banks (such as Bank of England, Federal Reserve) – these organisations inject cash into their country's money supply, set the lowest level of interest rate (known as the base rate) and are lenders of last resort
■ Banks (who are generally lenders of money)
■ Commercial organisations such as industrial companies (who generally need to borrow money).
All interest rates derive from the base rate. This is the rate the central bank will charge for secured overnight lending.
Banks will lend to each other at a slightly higher interest rate than this base rate. The average interest rates at which banks are currently lending is known as LIBOR (London Interbank Offer Rate).
Banks will charge a yet higher rate to commercial organisations and others. This rate will depend on the credit worthiness of the organisation and how much profit the bank is trying to make.
Let's now examine the interest rate asset class.
Here we describe typical products which are commonly grouped into the asset class of interest rates.
A deposit (or loan) is a simple instrument. One counterparty gives an amount of currency to another counterparty, expecting its return on a future date. At agreed regular intervals, interest will be paid by the receiver to the depositor.
A deposit can be unsecured or secured. When secured, the receiver has to provide some collateral to the depositor and in the event of default, the collateral will be forfeited.
The