Money Back vs Cash Back: The Distinction | PlayOJO Blog

Money Back vs Cash Back: The Distinction | PlayOJO Blog

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Money Back vs Cash Back: The Distinction | PlayOJO Blog -

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The relative ranking of the noteholder and swap counterparty varies. Many investors are unaware this occurs. Other investors are aware of the distinction and often will not tolerate this.

They insist the bank provider of the swap hold a pari passu position to the noteholder, and sometimes request a subordinate position to the noteholder, although this may not be acceptable to the bank derivative provider.

Limited recourse means that payments are owed by the SPE only to the extent that equivalent amounts are received on the underlying assets.

To the extent that there is a shortfall, claims are extinguished. After enforcement of the security, no further action may be taken against the SPEs, and no winding-up proceedings may be taken.

Limited recourse provisions exist with respect to the noteholders, swap counterparty, security trustee, charitable trust directors, paying agents, administrator, and any other parties involved in the transaction.

The Cayman counsel will recommend the board of directors, who are independent of the bank setting up the SPE. The board must be comprised of Cayman residents.

If the initial proposal allows the board to consider deal proposals from outside banks and companies, they may do that, too. The SPEs will purchase assets and will have the power to execute derivative transactions.

The SPE receives a small fee for each transaction accepted by the board. That is usually all of the deals. The SPE purchases separately funded dedicated assets for each note.

Each set of assets or single asset has its own EMTN tranche combining the risk characteristics of the underlying assets and derivatives.

The proposed SPEs will not engage in participations of loans on the U. In this example, the SPEs can purchase receivables and leases. The SPEs may also hold credit derivatives and other derivative instruments as assets.

Notice that eligible assets include assets on which withholding tax has been levied by the country of origination, even though withholding tax cannot be reclaimed by the Cayman Islands.

On a net revenue basis, these assets are normally noncompetitive with structures that are able to capture gross revenues on assets.

The SPE purchases assets. The bank arranger provides the structured coupons due to the investors under the EMTN issue. The bank arranger or a third party acceptable to the EMTN investor is the swap counterparty to all derivatives transactions with the SPEs.

These include insurance company funds, independent funds, banksponsored funds, corporations, insurance companies, commercial banks, merchant banks, investment banks, savings banks, regional banks, and U.

The reason the bank arranger sets up the vehicles is to satisfy various investor needs. The following are some of the repackaging uses of an SPE: The SPE can issue notes linked to individual loans or clusters of loans for investors who cannot service loans or purchase loans outright.

The SPE can issue freely transferable notes, even if the underlying asset is a securitization of funding agreements, with limited tradeability.

The SPE can issue notes linked to a portfolio of trade receivables. The SPE-issued note can embed derivatives in the note for investors with regulatory restrictions, or who lack capacity to enter into derivatives transactions.

This is particularly useful for transactions that embed a high degree of counterparty exposure. Examples include long dated transactions and highly leveraged transactions.

The note is securitized by collateral purchased by the SPE and frequently—but not always— selected by the investor.

If eligible collateral from a single A-rated bank with a higher funding cost is used, the collateral can generate more implied income on the EMTN issue.

This income may be passed on to the investor. An unwary investor may agree to any highly rated underlying collateral, but may not be sensitive to the nuances.

Some bank arrangers pocket all of the additional spread if the investor is unaware. One bank arranger, who employed this strategy, asked me the following question: I just want him to be able to put the asset swap on a certain date.

I realized I was asking the next question a little late, but now I was curious. I knew the answer already, but I wanted to hear him say it.

Instead he asked another question. He seemed to be feeling better already now that he had halfway persuaded himself he was out of the woods.

The agreed price is just that, and a bank arranger might include some compensation for additional repackaging. Who takes that risk in this transaction?

What if the investor wants to sell before maturity? Who eats the present value of 10 bps per annum for 3 years? Somewhere in the documentation you have to disclose what constitutes eligible collateral and the fact that the price risk upon liquidation is borne by the investor.

Rationalizations are more important than sex. We can live a day without sex, but have you ever tried to go a day without rationalizations?

Think about this from your own perspective. Are you indifferent between the risk of an AA-rated bank deposit versus the risk of that deposit combined with the risk of the AAA-rated equity tranche?

He played the short game. Even the shorter form documentation used for these transactions can be daunting. The documentation might state that eligible collateral is rated single A or higher, or it may state that eligible collateral must be rated AA or higher.

It may specify that securitized assets and ABSs, among other types of collateral, are eligible. The collateral is not a blind pool.

The investor can negotiate the type of collateral and the compensation for the collateral. Investors should ask detailed questions; it pays economic rewards.

The idea is that the investor should be aware that is the case, and aware of the risks. Furthermore, it seems reasonable that any aware investor who is happy with this collateral would attribute part of that 67 Structured Finance and Special Purpose Entities happiness to a higher spread earned on the EMTN.

Extra income can be created in a number of ways. Often, only the principal portion of these notes will be rated.

This structure is popular in Europe. If A tranches are issued, U. Loans can be repackaged and sold to investors in note form.

Another variation is to repackage a credit derivative referencing the loan with underlying collateral purchased by the SPE to create a CLN. European investors often want access to loans to leveraged borrowers.

Many funds cannot purchase loans, but can purchase loans repacked in the form of an EMTN. The historically high recovery rate of the loans make this a desirable alternative to high yield bonds.

The bank sponsor usually marks the EMTN to market for the fund and services the loan. Most transactions are cash settled, and recovery value is market price of an allowable reference obligation for the reference obligor that is the first to default.

Any price change is knowingly borne by the investor as in Figure 3. For instance, it is sometimes cheaper to lay off credit risk in the form of a CLN than it is to buy credit default protection in the credit derivatives market.

Theoretically, the bank could sell the underlying asset outright, but that may not be a politically acceptable alternative.

This usually happens when the asset is a loan. The investor has the right to sell an EMTN at any time.

In absence of a default of the underlying asset, the investor typically solicits bids from dealers for the asset and derivatives transactions if any and compares this with the bank sponsor provided mark-to-market.

Rated programs may incur further charges. The cost will depend on the complexity of the structure and the number of changes the bank inevitably requires during the setup process.

Listing, rating agency fees, U. The documents required for both programs are very similar, which reduces the cost. Separate legal opinions per tranche are required by the rating agencies for all tranches issued by SPEs with any outstanding-rated tranche.

These costs are avoided by dedicating one of the SPEs to issuing only unrated product. The bank swap provider has potential market risk exposure due to the fact that it is providing a hedge to the SPE.

A default of the underlying assets triggers an early redemption event for the EMTN. The underlying assets secure the EMTNs and the swap, and are held in either a bank custodial account for non-Euroclear eligible assets or a custodial omnibus Euroclear account.

If the unwind is triggered, the security trustee sells the assets at prevailing market prices and the proceeds are passed to the EMTN investors and to the bank swap provider in order of the seniority set up in the note agreement.

The security trustee pays in order of seniority. For instance, if the seniority is pari passu, the EMTN investor and the bank swap provider will get a pro rata payment based on the par value of the EMTN and the positive markto-market on the swap.

If there is a negative mark-to-market on the swap, the proceeds usually remit to the bank swap provider, although the disposition of this payment is sometimes negotiable.

These conditions are known as the unwind triggers. The unwind trigger will ensure the early termination of the EMTN, to prevent the possibility that a combination of market movement and price decline of the underlying asset might fail to cover the positive mark-to-market value if any to the bank swap provider.

As mentioned before, the security trustee administers the unwind of the EMTN, which includes liquidation of the underlying asset and payment of any positive mark-to-market.

Unwind triggers may vary by repackaging. Unwind triggers are set to liquidate the underlying assets to cover the expected potential market risk exposure of the bank swap provider.

A dynamic trigger is the most common type, but riskier transactions may have multiple unwind triggers. A key factor in determining unwind triggers is the degree of liquidity of the underlying asset.

Illiquid assets may require different trigger strategies and trigger levels. The documentation of each EMTN series provides full disclosure of all unwind triggers.

This is known as the gap margin. This trigger will be set based on several factors: As an added fail-safe feature, this dynamic trigger can be scaled to decline as the public credit rating of the underlying asset declines.

These are also called knock-in unwinds. Default of the underlying asset, regardless of price, is an unwind trigger. The SPE purchases the U.

The bank sponsor has risk when there is a major price decline in the underlying secondary paper and when the Euro depreciates sharply against sterling.

For purposes of assessing mark-to-market movements, the interest rate risk of the one-year underlying U.

The bank sponsor estimates the underlying U. Furthermore, the bank sponsor believes that downward moves in the Euro will be orderly declines rather than extreme overnight gaps.

The bank sponsor chooses a dynamic trigger based on this assumed maximum market price decline during the liquidation period.

Since it believes 20 percent is a safe gap margin for this asset, it sets the trigger so an unwind will occur if the positive mark-to-market of the swap reaches 80 percent of the asset market bid price.

The asset and swap are marked-to-market daily and compared with the trigger. The bank sponsor also makes the gap margin dynamic. The gap margin is scaled to change with the rating of the underlying security.

The bank sponsor also sets static triggers. Because of the automatic unwind trigger if the U. When dealing with emerging market securities, or when dealing with soft currencies, certain considerations need to be emphasized.

When determining mark-to-market exposure, correlation between the mark-to-market of the swap and the underlying asset is a factor.

Right-way-around swaps are those in which a bank sponsor receives the soft currency and pays a hard currency.

The bank sponsor exposure is likely to be very low. The soft currency is unlikely to appreciate after a default of the underlying sovereign asset.

This means the bank sponsor will not be owed money under the swap agreement, rather the bank sponsor will owe money under the swap agreement.

This is a mitigating risk factor for sovereign assets. Wrong-way-around swaps are those in which the bank sponsor receives a hard currency and pays a soft currency.

The bank sponsor is likely to have more exposure and the liquidity and the credit quality of the underlying asset is of much more concern.

Not all assets will be sovereign assets, however. Single currency swaps in hard currency have less exposure than the same type of swap in a soft currency, and there is often little correlation between the swap mark-to-market and the underlying asset quality.

The rating agencies review all new rated issues to ensure the new issues will not impact the rating on existing securities. If the bank swap provider holds a senior position to the noteholders, the rating agencies will usually not allow an EMTN issue to have a rating higher than that of the bank swap provider.

A deal arranger may employ a credit wrap on either the swap or the underlying assets to enhance the overall rating of an EMTN series.

Reinsurance companies and highly rated banks are all providers of credit wraps, for a fee. This innovation enhanced investor appeal of securitizations of short-dated assets such as credit card receivables, and long-dated assets such as European mortgage backed securities MBSs.

Credit card receivables have been the dominant asset for master trusts, but others are gaining popularity.

The advantage is that if a series has a target maturity date, principal payments can be made from any asset in the trust.

Inevitably some new terminology was developed along with the master trust structure: As we know, the pass-through structure simply passes through principal and interest payments.

This is also known as an uncontrolled amortization or fast pay structure. Revolving term securitizations have a revolving period followed by a controlled amortization period also known as the payout period.

The nonamortizing revolving period followed by an amortization period is used most frequently for credit card receivables, although the next structure is more popular.

A soft bullet structure aims to pay back principal on an expected maturity date. There is an initial revolving period, but principal payments after the revolving period are collected in a principal funding account and reinvested to be paid back in a lump sum at an expected, but not guaranteed, maturity date.

For securitization of short-term assets such as credit card receivables and trade receivables, the soft bullet is currently the most elegant and popular solution available.

The hard bullet or bullet structure has a guaranteed principal repayment at a preset maturity date. The guarantee is usually accomplished by purchasing third party liquidity enhancement.

The added certainty and added cost are not deemed necessary by most investors. Investors like the soft bullet structure. As a result, they are Structured Finance and Special Purpose Entities 77 gaining in popularity, even for auto, student, and equipment loan securitizations.

This structure allows seniority tranching and different maturities for bonds. For tax purposes, the equity piece is structured to look like a bond.

The documentation states that if somehow the entity becomes taxable, it would convert to a partnership and pass income and expenses through to the partners, thus avoiding the entity level tax.

As such, they do not attract entitylevel taxes. In other words, they are passive tax vehicles. Grantor trusts have other general drawbacks. Investors receive principal and interest on a pro rata basis.

No time tranching is allowed, although the trust can tranche senior and subordinated bonds. Since the payments occur over the life of the transaction, the wide payment window of the grantor trust structure has limited appeal to many investors.

This structure avoids entity level taxation. The residual must be owned by a taxpaying entity. The transfer must be done in such a way to ensure that taxes associated with the residual interest will be paid.

To transfer this asset, the owner makes a payment for the tax loss along with the transfer of the asset.

Another investor with a tax loss offset could become the low bidder and avoid paying tax on the residual interest.

If the transfer is not done correctly, it may be disregarded for tax purposes, and the original owner becomes responsible for the residual interest tax liabilities.

Since these regulations are subject to change, they should be rechecked at the time of the transaction.

They are rarely used because gains, if any, on the sale of assets to a FASIT are taxable at the time of the sale.

Multiseller conduits buy interests in pools of assets mainly receivables from a number of different sellers and issue indivisible obligations, usually asset-backed commercial paper ABCP.

Banks set up most conduits, although a few fund groups have also done so. Unlike the MIE we examined earlier, conduits primarily use short-term funding with a claim against the entire pool of assets owned by the conduit.

Conduits use an interest rate hedge overlay for the entire program life to minimize gap risk. Structured Finance and Special Purpose Entities 79 Assets must meet the credit requirements of the conduit.

The seller might be asked to overcollateralize, to sell a senior portion and retain the subordinated piece, or to allow limited recourse back to the seller.

They often receive pressure to introduce assets of bank customers into the conduit. The asset securitization groups of banks with poor underwriting and distribution capabilities sometimes set up conduits to pool unsold assets.

Investment banks with strong distribution capabilities frown on the use of conduits for this purpose.

Investors in conduit ABCP should take this into account when evaluating various conduits. Conduits also use program-level credit enhancement, which applies to the entire asset pool.

This includes credit wraps in the form of surety bonds and a letter of credit LOC from the sponsoring bank.

Since banks are currently not required to hold risk-based capital against obligations shorter than days, these facilities are usually days long.

These have to be renewed, and the renewal cost, or repricing risk, is always a factor. Conduit sponsors sometimes represent that liquidity lines are virtually risk-free.

The lines are not risk-free to the providers, however. A commercial paper market disaster could result in drawn liquidity lines without immediate means of repayment.

This may include limited recourse to the seller, overcollateralization, or subordination. Conduit usually has an interest rate and sometimes currency hedge overlay for the entire conduit to minimize gap risk.

Bank managers have noticed that the lines are not risk-free and seesaw in their willingness to provide them.

Some banks will not provide liquidity lines for outside conduits. The size of the program varies depending on the timing and volume of the receivables of the various sellers.

Some corporations are not meant to issue bonds, but provide a means for investors to take degrees of credit risk through either equity shares or loans.

For example, in the German market, a Gesellschaft mit beschränkter Haftung GmbH corporate structure is sometimes employed.

The GmbH has both lenders and shareholder s. The shareholder s Komplementär are fully liable partners.

The shareholder is often the bank arranger. The costs of setting up the structure are usually cheaper than for an offshore SPE.

The lenders loan money to the corporation and have a higher credit quality risk than the shareholders. The credit risk of the loan is investmentgrade equivalent risk.

These investments are not listed and are not rated. There is also no need for an offshore securitization vehicle. Local corporate tax regulations apply, and from this point of view, the transaction may appear more transparent to German participants.

If a bank is the seller of the assets, then protection from bankruptcy of the original owner is usually not an issue, at least in the United States.

The SPE is a specially created corporation or trust that is bankruptcy remote from the original seller of the assets.

Usually this means that the SPE must be legally independent of the seller. Sellers want to avoid creating a taxable event by the sale of assets.

Tax laws are independent of bankruptcy treatment and accounting treatment. The securitization is usually structured as seller debt for tax purposes, but as a sale for bankruptcy purposes.

If the deterioration is very swift, however, there may not be time for replacement before the bankruptcy court gets involved.

Different countries take different positions on bankruptcy law. It is important to review the price that the assets are sold to an SPE under true sale at law.

For example, in the United States, this might be viewed as a fraudulent conveyance, and the sale could be voided. Of course, rated deals will have opinions as to the legality of the transfer of assets and Structured Finance and Special Purpose Entities 83 the fair price transfer of the assets.

These are only opinions, however. Opinions can be overruled. Many venues have rules against preferential payments. If you received deal payments from an issuer, or if you received support agreement payments from a credit wrap provider who subsequently declares bankruptcy, these payments might be deemed to be preferential.

Payments made in the ordinary course of business are exempt from preferential status, and a legal opinion showing that the payments satisfy a series of conditions can be issued.

In the United States, banks and thrifts are not subject to the bankruptcy code and are not subject to the same preference risk, at least theoretically.

In the case of proven fraud, however, the Federal Reserve could potentially step in and reverse the transaction. Their mandate is to protect the banking system, not investors in fraudulent transactions.

The Federal Reserve would be reluctant to do this, because securitization is a key tool of U. Structural protections work for many of the payments due to investors.

Some conduit structures will have a clawback letter of credit that allows investors to claim reimbursement if any of their payments are reversed because they are ruled preferential.

Rules may change, so there is no substitute for checking with lawyers in each venue to maximize the probability that a deal will always be viewed as bankruptcy-remote from the sponsoring entity.

Even when a deal is bankruptcy-remote, the investor may make decisions that result in bankruptcy risk. One obvious trap is to invest proceeds in the collateral of the sponsoring entity.

The collateral is subject to bankruptcy risk of the sponsor. Investors can protect themselves by insisting the documentation asks for nonsponsor collateral.

You already have the documentation risk to the sponsor, so why add additional risk for a given deal? Morgan acted as administrative agent.

Enron sold receivables to the bankruptcy-remote SPE, but invested the cash in Enron commercial paper. On a purely statistical basis, the rating agencies each publish their own transition matrices.

This shows the probability of a single asset being upgraded or downgraded based on historical corporate data. With these probabilities, we could use a simple binomial tree to calculate a horizon price in one year.

This would then allow us to calculate a horizon value and an expected return for the asset. Similarly, we could do this analysis for a portfolio of assets see Figure 4.

The second risk is a general widening in credit spreads, which will cause the price of the asset to decline. The third risk is the risk of default by the obligor.

If you look at data for another time period, the default rates will differ somewhat from those shown in the table.

The portfolio also has market risk. Of course, it is also possible that an asset can be upgraded or that credit spreads can tighten.

It is also possible that interest rates and currency rates move in a direction that enhances portfolio value. This bodes well for the future of CDSs as the hedge instrument of choice for credit event risk.

A CDS is a transaction in which the credit protection buyer pays a fee, usually called a premium, to a credit protection provider in exchange for a payment if a credit default event of a reference asset s occurs.

The protection buyer is the seller of default risk. The protection seller also called the protection provider is a buyer of credit risk.

The protection seller is often called the investor and makes no payment unless a credit default event occurs. The protection seller and the protection buyers are called CDS counterparties.

CDSs are sometimes called credit default options, but market professionals usually use the former. The contingent payment is determined based on prespecified settlement terms.

France and the United Kingdom only give a 70 percent risk weighting credit to this hedge. Australia recognizes a percent of the maturity matched.

It may be that because banks do not yet mark their balance sheets to market, the United States views default risk as the source of all credit risk for hedging purposes.

Needless to say, the trend will probably evolve to a common agreement on how to recognize the hedge across venues.

A key feature of a credit derivatives contract—unlike an insurance contract—is that the protection buyer does not have to suffer loss as a result of a credit event in order to get paid under the terms of a credit derivatives contract.

In the United Kingdom, this feature exempts credit derivatives from the necessity to get authorization under the Insurance Companies Act of , because a credit protection buyer under a credit derivative does not have to hold an underlying obligation in order to get paid.

In some venues, insurance companies can raise other issues as a defense against paying out under the terms of an insurance contract.

See also Chapter 8: Morgan, and Offshore Vehicles. When trading books are used, credit derivatives are off-balance sheet transactions.

For instance, a bank can use a CDS to transfer credit risk of a loan, and does not need to notify the borrower. The bank retains legal ownership of assets while hedging default risk.

This is particularly useful when assets are under water below their initial book value , because a sale of the loan would require the bank to recognize a loss.

Structurers can tailor credit risk in terms not available in cash markets. Structurers can also create arbitrage opportunities not available in cash markets.

Finally, structurers can hedge any type of credit exposure, even anticipated exposure. Just about any contract imaginable can be created. The key issues in the CDS market revolve around pricing and contract language: Determination of the default protection fee.

Determination of the reference asset or the allowable deliverables potential source of basis risk. Determination of the default payment potential source of basis risk.

In the current market, fees are usually paid like swap payments—quarterly in arrears—but any negotiated payment structure is feasible.

For instance, it can be purchased on an asset swap package, a loan, a bond, receivables, tranches of CDOs, sovereign risk due to cross border commercial transactions, or even on credit exposure due to a derivative contract such as counterparty credit exposure in a cross-currency swap transaction.

Credit protection can be linked to an individual credit or to a basket of credits. Suppose an investor wants to own the risk of a corporate loan, but the investor is not allowed to buy loans.

The investor can sell credit protection buy credit risk on the loan, and use cash settlement. The credit protection buyer can even buy credit protection on a notional exposure, such as the exposure an interest rate swap desk might have to a counterparty in an interest rate swap.

Conversely, a protection seller does not ever have to take delivery on a defaulted asset. The settlement can be a cash settlement referencing the loss on an asset or on a notional exposure.

In this example, the CDS uses physical settlement if a credit default occurs. In cash settlement, the protection seller does not take delivery of the asset, but makes a net contingent payment equal to par minus the market price.

The market price is the postdefault price, or the recovery value, of the reference asset and is usually determined by a dealer poll.

Par minus the market price equals the loss on the reference asset, so the protection buyer is made whole on the initial value of par.

The credit default option or swap is a contingent option. The protection seller makes a termination payment only if a credit event occurs.

If the credit event does not occur, the default protection seller has no obligation. The Investor receives the floating coupons and receives par at maturity unless there is a credit default event.

If there is an event, the asset is worth the current market price, or recovery value. If the FRN obligor defaults, the protection seller pays par for the floater and takes delivery of the FRN, which is worth only the current market value, or recovery value.

That seems like a knock-in option or a knock-in swap, which is a type of barrier option. The knock-in is triggered by either a credit default or a credit event.

If the option knocks-in, then and only then is the option in the money. Any negotiated payout in the event of default is feasible.

It can leave a position of premium bonds partially unhedged or can overhedge a position of bonds trading below par. Settlement is usually cash. There are two types of digital payouts.

The all-or-nothing also known as the zero-one payment is equal to the entire notional amount. The investor loses the entire notional amount—not merely coupon and some principal loss—if there is a default event.

I believe there is no need to offer credit protection on the entire notional amount for a CDO, since recovery rates are usually greater than zero.

The second type of digital payment is a pre-agreed cash payment in the event of default. For example, this might occur if the credit exposure is due to a cross-currency swap with a reference obligor.

The reference is the notional exposure of the cross-currency swap. If a credit event occurs, daily price volatility can be enormous. Emerging market debt spreads are often highly volatile.

If the protection buyer wants to protect itself against this possibility, it may make sense to agree in advance on a fair default payment.

When the reference asset is trading well above or well below par, this settlement calculation is a better option. When assembling a portfolio, a CDO structurer or CDO manager should try to incorporate this language when a reference asset is trading below par.

The CDO portfolio is long the credit protection seller and receives the fee. Credit Derivatives and Total Rate of Return Swaps 93 When a desired reference asset is trading well above par, and when other assets of the same reference obligor trade well above par, it may be useful to employ a different strategy.

It might be worthwhile to execute a standard CDS and agree to pay only par minus market value on an allowable set of deliverables. Investors should look at the language of deals to see if an attempt was made to get the most favorable terms on synthetic exposures.

Most credit derivatives desks feel this is too complicated. Rather, they adjust the calculation amount of the transaction in an attempt to compensate the default protection seller for the potential additional termination payment.

The price decreases to par if the reference asset initially trades above par. The price increases to par if the reference asset initially trades below par.

The spread of the reference asset to a risk-free asset, such as an AAA treasury security, is input into a bond pricing calculator. That way, as the reference asset approaches maturity, the price of the shorter maturity proxy bond can be used as the reference price to calculate the termination payment.

This method is almost never used because most practitioners do not want to draft the language, but there may be times when it pays to do this.

Suppose a buyer of protection asks for credit default protection on a par asset swap package. The buyer may ask for a par minus market value payment plus accrued interest plus hedge costs.

It is important to note that the seller of protection does not usually get a rebate if there is a net market gain in the hedge.

This is tricky for the seller, because the theory is that the hedge costs make up for any price difference from par of the reference asset.

This practice is even used in multicurrency structures in which an issuer may hedge a nondollar asset to dollars.

CDOs of cash assets often require currency hedges. For example, a bond denominated in U. Sometimes a manager will ask a deal arranger to provide a hedge so that if the underlying reference asset defaults, the arranger will unwind the hedge at no cost to the deal.

If the arranger agrees, a credit contingent option to unwind a cross currency swap at no cost to the deal is added. Synthetic arbitrage CDOs, for example, provide credit protection to the structuring bank or structuring investment bank that arranges the deal.

When the arranger sells protection, however, the arranger will attempt to limit deliverables to the most expensive to deliver possible. We call this cluster of exposures reference obligations.

In the current market, it is popular to reference borrowed money, which usually means bonds and loans. Many dealers will try to say this is the standard contract and therefore more liquid.

The basis risk results from the option of the credit protection buyer to produce the cheapest to deliver. The credit protection buyer may own a loan, but under the terms of the contract can buy a discounted bond in the marketplace and deliver this instrument, thus getting a higher payout under the CDS.

The seller of credit protection does not have to accept whatever the market wishes to dish out. Das Restprogramm der Bundesliga im Überblick.

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