Question

3. (a) Define the term ‘credit risk’ and describe the key inputs required in models of credit risk. (b) Suppose that you are working for a bank who has lent €5 million Euro to firm YZ. Your manager is concerned about its ability to meet its repayments. Advise your manager as to how you can hedge this credit risk? Provide a numerical example. (c) An American call option on a non-dividend paying stock, with a strike price of $100 and an expiry date in six months, currently sells for $5. The underlying asset currently trades for $95 per share and the risk-free rate of interest is 10%. What are the upper and lower price bounds for an American put option written on the same stock, with the same strike price and same time to maturity? Why is it not possible to derive a parity condition for American options on non-dividend paying stocks?

Answer 1

(a) A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

(b) I will advise my manager that he/she can opt. any of the given below options to hedge the risk of 5 million Euro:

1. Binary Credit Options (Puts/Calls): These will pay off if a "specific negative credit event" occurs. If it doesn't, only the premium is lost. These also protect against bond price changes and can be used to protect against any of the risks discussed above.
2. Credit Spread Options: These pay off if the spread on the bond you're insuring rises above a certain level. If it doesn't, only the premium is lost.
3. Credit Forwards: These lock in a commitment by both parties to pay off (or, rather, one party will pay the other) based on a bond's price or spread at a specific time. Just like any other forward contract, these are symmetric, which means that what the winner wins is equal to what the loser loses. Remember that the payoffs on these contracts are multiplied by a risk factor. These are useful in protecting against credit spread risk.
4. Credit Default Swaps: These are not much different from the products described above. You pay regular premiums to a CDS dealer, who will pay off in the event of a "credit event". These instruments are often used to protect against default risk and downgrade risk.