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INSIDE A CREDIT TRADE

Intimidated by credit derivatives term sheets? Here's a guide to the details associated with a typical trade.

COUNTERPARTIES

Counterparties

  • Must be the exact trading name of each party, with location if possible.
Reference Entity
  • Use multiple reference entities for clarity, such as “Citibank NA including Citicorp” or “Hungarian Republic including the National Bank of Hungary.”
  • Use “and any successors” in case of mergers or name changes.
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DEAL DATES

Effective Date

  • Deal terms, including price, are locked in on the trade date, which is usually three days before the effective date.
  • Credit protection is only valid on the effective date, and the deal does not cover any credit event that occurs before that date.
Termination Date
  • The deal terminates on the earlier of the documented maturity date of the swap or the occurrence of a credit event.
  • In cases in which termination is to occur following a credit event:
    • publicly available information is used in all situations unless this will be difficult to obtain.
    • materiality is used only in rare situations, and is not used in the interbank market. Materiality must exist as well as a credit event—it is not an independent trigger.
Scheduled Termination Date
  • This is the last day on which a credit event can occur.
  • Fixed rate accrues to this date.
  • It will be adjusted as per business-day convention.
PAYERS

Floating and Fixed-Rate Payer:

  • The floating-rate payer is the protection seller (or risk buyer).
  • The term floating is used to mean contingent.
  • The fixed-rate is accrued up to and paid on the termination date.
  • Semiannual is the market standard; quarterly reflects a lower rate.
  • Any up-front fees must be accompanied by a “claw back” in case of an early termination.
CASH SETTLEMENT

Initial Price:

  • The market standard is to calculate from an initial price of “par.”
  • The “reference price” is used when a credit event is imminent.
Final Price:
  • The “highest bid” is most common and reflects the sale price of an equivalent cash asset.
Dealer Panel:
  • It is not usually necessary to name the dealers at the start of the deal. They can be agreed upon after a credit event.
  • For illiquid reference assets, it is better not to use a dealer panel but to set the final price equal to “the price at which the reference asset is sold in the open market.”
Timing:
  • The market is trying to standardize around 20 days.
  • A longer delay means a more settled market.
PHYSICAL SETTLEMENT

Floating-Rate Payer:

  • The floating-rate payer (risk buyer) normally pays only the calculation amount against a general deliverability clause.
  • The reference price and accrued interest are used if a credit event is imminent. In this case there will be a specific delivery clause.
Timing:
  • The market not very standardized here. Timing is usually 14 days.
Quantity:
  • Another acceptable variation is the sum of face value plus accrued.
Deliverable Obligations:
  • The market standard is for any obligation to 10 years in a G-7 currency.
  • Deliverables must be issued or guaranteed by the reference entity and bear interest.
  • They can be bonds or loans but not LCs or discount instruments, unless the documentation is specifically changed.
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CREDIT EVENTS

Failure to Pay:

  • This is used in all deals, and covers all “obligations” in which the missed payment is greater than the payment requirement.
Restructuring:
  • This is used in all deals. Note that such an event must be materially less favorable.
    Bankruptcy:
    • This is used in all non-sovereign deals.
    Cross-Default:
    • This is most common. Some deals use a similar term called “cross-acceleration” instead. One or the other is used in every deal.
    • This covers all “obligations” in which the sum of the notional values is greater than the default requirement
    Payment Requirement:
    • This is the actual amount of cash that has to be missed under “Failure to Pay.”
    • It should realistically be less than the default requirement, but the market still uses $10 million quite often.
    Default Requirement:
    • This is the notional value of obligations that falls into cross-acceleration or cross-default. The market standard is $10 million.
    Obligations:
    • This is not directly related to deliverable obligations.
    • These are the obligations that are monitored to see if a credit event occurs.
    • The whole definition can be replaced by the “Reference Obligation” if the deal is to be linked to one asset only.
    BUSINESS DAYS

    Business Days:

    • Always include the operational center (London, New York and so forth) and the currency center.
    Business-Day Convention:
    • This usually reads as “modified following…”
    CALCULATION AGENT

    Calculation Agent:

    • Often this is a joint agency between between the bank and the counterparty.
    • Many dealers allow a professional market-maker to be the sole agent if required, but not a new counterparty.
    • This does not have to match the calculation agent as defined in the ISDA master agreement.
    DOCUMENTATION

    Many dealers insist on having an ISDA master agreement in place before trading.

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    REFERENCE ASSET

    Applicability:

    • A reference asset is only required:
      • when there is cash settlement or materiality. In this case the asset must be liquid and widely traded.
      • when the deliverable obligations are limited to one asset.
    Reference Name/Issuer:
    • Give the exact issuer name, and details of any guarantor.
    Reference Price:
    • This is usually par, although other prices are applicable if materiality is used or if physical delivery is against a price other than par.
    Substitution:
    • The termination provision is only applicable for deals in which the reference asset is used to calculate materiality.
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