Creating A Suitable Basket
A basket of credits needs to be carefully chosen to provide the desired level of leverage to the protection seller. A basket that is based on credits with a low likelihood of multiple defaults (i.e. low correlation) would provide the seller with the highest leverage. We would also expect such a basket to be relatively high yielding.
It makes more sense to use investment grade rather than high yield credits in a basket. Even though the high yield credits in a basket may be uncorrelated, the higher individual probabilities of default associated with each high yield credit could lead to simultaneous multiple defaults. In the event of a single default, the non-defaulted high yield credits may have deteriorated significantly to make purchase of new protection on them extremely expensive. Investment grade credits, on the other hand, would be less likely to experience such credit deterioration. If one member of a higher quality basket defaults, it is quite likely that the others can be rehedged at cost-effective levels.
Basket Sensitivity
Basket premiums are driven by several factors including default correlations, the number of credits in the basket and the quality of the credits. In order to examine the sensitivity of the basket premium with respect to some of these factors, we use a sample basket with the following characteristics:
* Five reference entities, five-year maturity;
* EUR10 million notional amount;
* each single-name default swap trades at 100 basis points.
Correlation
As explained in an earlier Learning Curve article1, correlation drives the risk/reward tradeoff in a basket structure. The greater the correlation, the greater the probability of multiple defaults, i.e., the lower the value of protection to the buyer. Chart 1 highlights the relationship between the basket premium and correlation for our sample basket.
Number Of Reference Entities
Assuming constant correlation, an increase in the number of credits increases the basket premium (Chart 2). As more credits are added to the basket, the risk of the first-to-default event increases and the seller requires a greater level of compensation. However, the rate of increase in the basket premium declines with an increase in the number of reference entities. From a dealer's perspective, balanced baskets with three to seven reference credits can be hedged most effectively. More credits would imply low deltas (and therefore low hedge notionals) resulting in lower market liquidity to set up the hedges.
Default Premium
Chart 3 shows us the movement of basket price with a change in default premiums for all the reference entities in the basket. As the premiums increase by equal amounts for all the credits, the risk of the first default of the basket increases. If basket entities are uncorrelated, we note that the price of the basket is equal to the sum of the individual default premiums
Basket structures make more sense for credits that are trading at similar spreads or those that have similar credit ratings. If one of the credits is extremely weak, then it would dictate the pricing of the basket making the protection on the other credits less valuable. This is demonstrated in Chart 4 for the same basket of five credits. The chart plots the basket premium as the single-name default premium of one of the credits widens while that of the other four remain steady at 100bps.
Strategies
Investment Motivators
First-to-default basket swaps cannot be replicated in the cash market and provide unique benefits to investors in terms of relative value and leverage.
* Improving portfolio yields: As credit spreads tighten, unleveraged investments in individual credits could fail to meet portfolio yield hurdles and become less attractive. In order to improve yields, portfolio managers can expand their gamut of investment opportunities by investing in lower rated, higher yielding assets. Alternatively, they can sell protection on a basket of approved names that meets the yield hurdle even though the single-name default swaps on the reference entities may not meet the hurdle on their own.
* Express a view on correlation: Investors who believe that a group of credits have a higher correlation than that expressed by a basket swap on the same credits can express this opinion by selling protection on the basket. This trade looks more attractive as investors' opinion of correlation increases relative to that expressed in the market price of the basket.
* Protection from a credit landmine: Accounting and related uncertainties have increased concerns about unexpected deterioration for a particular credit. Though an investor may make the right sector allocations, sudden and sharp credit deterioration, such as in the case of Enron, could severely diminish portfolio returns. Investors can mitigate the effect of a credit landmine by buying protection on a basket swap. Though this protection would reduce overall portfolio returns, investors would be protected in the current uncertain financial environment.
Investors also need to be aware of some of the limitations of FTDBs.
* Liquidity: Basket swaps are investor-specific and typically negotiated for baskets selected by investors for specified maturities. Investors can usually sell basket protection in maturities that correspond to the liquid single-name default swaps, usually five years.
* Cheapest to deliver risk: Protection sellers take on cheapest-to-deliver risk following a credit event. Physical settlement of the basket swap will likely consist of the lowest priced bond ranking pari passu with the reference obligation of the entity that experienced a credit event. This risk, however, is not specific to baskets. Since baskets are special forms of credit-default swaps they share similar characteristics.
Investor Strategies
The potential benefits of basket investments can be translated into clear trading strategies for investors who wish to express particular views. We discuss some of the strategies below.
1. Creating leveraged positions: As discussed above, as credit spreads tighten investors can sell FTD protection on a basket of approved names to increase portfolio yield rather than moving down the credit curve and investing in high-yield credits. Though the basket may consist of approved credits, the less than perfect correlation between them increases the risk of basket default relative to each individual credit.
2. Creating a synthetic "senior" position: Investors can take a long position in a small portfolio of credits and buy first-to-default protection on the portfolio. The net carry from this trade is lower than that from the individual credits but the trade is less risky as a loss will only occur if there are multiple defaults. Investors take the risk that the actual correlation is higher than the expected correlation increasing the likelihood of multiple defaults.
3. Credit convexity trade: Investors buy basket protection and dynamically hedge by selling single-name default swaps on underlying credits. The investor is long gamma and has a potentially large upside. Due to the hedge the downside is limited except when actual correlation is greater than expected correlation. This trade typically has a negative carry, is non-directional and does not require price convergence or suffer during price divergence like most long/short strategies. The key risk in this trade is that baskets are illiquid and the best way out of this trade is dynamic hedging until maturity. This requires active management and a commitment to follow and participate in the default swap market.
4. Creating a cheap senior short: Investors sell basket protection and buy protection on each individual credits. The net position is similar to being short the senior tranche in this portfolio. If this position can be set up at really low rates then the investor has a small negative carry. The trade is then equivalent to buying cheap deeply out-of-the-money portfolio puts that have a big payoff when the entire market blows up and there are multiple defaults.
Basket Premium Declines As Correlation Increases
Basket Premium Increases With Number Of Reference Entities In Basket
Basket Premium Increases With Default Premiums
Basket Premium Appoximates Premium Of Highly Distressed Credit
This week's Learning Curve was written by Atish Kakodkar, v.p. in the credit derivatives research department at Merrill Lynch in London.
