Case Study - Credit-Linked Notes
Credit linked notes are assets issued by financial institutions which have exposure to the credit risk of a reference Issuer. These notes pay an improved rate to the investor for taking on this additional credit risk. If the Reference Issuer defaults subsequently the investor receive the recovery price of the reference security. Mainly credit linked notes are issued as traditional medium term notes that contain embedded credit default swaps.
Example:
Drug company Credit Linked Note
Termination Date: 5 Years
Reference Security: ABC bond 7.125% maturing 12/1/09
Interest: Libor + 50bp per annum. Quarterly paid Interest.
In this CLN the investor receives Libor + 50bp coupon against the exposure to the default risk of the drug company in an asset backed trust.
Therefore a CLN will be preferable to a straight Treasury if the investor desires a higher coupon associated with the risk of default of a certain security.
(b) Investment banks may require hedging their position during the issuance process as the readings suggest. The process of pricing, packaging and selling a CLN may take time and during this period markets may move.
As dealers issue CLNs they will comprise short derivatives positions mentioned in the text in particular they will have short CDs positions.
(c) In the text the environment has been influenced by a shortage of corporate bonds in the secondary market. Note that while this happens the value of these bonds would go up and the associated risk premium would decline. As discussed this would directs to a lowering of the associated CDS rate.
(d) The arbitrage refer to this reading is in fact a true arbitrage in the academic sense and the logic of the arbitrage argument goes as follows.
A basket of corporate bonds is somewhat similar to a synthetic CLN packaged using the same names by a dealer. They both have introduction to an identical set of credits they include very similar default risks and they pay an enhanced coupon. Therefore in theory the difference between the coupon paid by the basket and the synthetic CLN should be the same.
Yet as discussed technical factors may perhaps make the two coupons diverge from each other. This is called as the bond basis. The text stated that this basis was negative originally and became even more negative as a result of the activity mentioned in the reading.
Those dealers who had right to use to the underlying bonds could then put together packages by selling and buying the underlying and the associated CLN.
To symbolize the cash flows in a graphic one would use Figure and put it together with the cash flows of a risky bond which will be similar.
(e) If a few bonds become special in the repo market this means that there is a great deal of demand for them. In such situation those players who want to borrow these bonds will be willing to surrender their cash to the repo dealer at zero interest.
(f) For the reason that if they have the bonds in their portfolio they give to bond to repo dealer and receive cash at zero cost instead of paying interest to banks.