Hi David, Would you please give an example to clarify what CLNs are? But please give parties of example names, all examples I found called them buyer, issuer and seller. For this kind of credit derivatives only I confuse them together. Also, I don't understand in CLNs whose default risk is being mitigated, and who is bearing that risk. Thank you
Actually there's a lot more that I don't understand about it but I think you'll explain all in a good example..like you always do Thanks
Hi hend, here my simplified notes (compilation of davids + core reading). Maybe it will help you. Credit linked note (CLN) Funded equivalent of a CDS Credit protection seller had prepaid the loss in the form of a bond, issued by protection buyer, whose cash flows are inversely related to prescribed losses on the reference portfolio. Interest rate is above-market. ·If no event : issuer repays investor scheduled principal + interest (no need for protection any more) ·If credit event : issuer can withhold interest and if necessary part of principal From protection buyer : equivalent to issue normal bond + buy credit protection (Par value of note = max payout on the CDS) From protection seller : knowing max amount to pay BUT bears credit risk of the issuer CDS : unfunded // exposes protection buyer to credit risk CLN : funded // exposes protection seller to credit risk adding : protection seller is the investor (pay PAR to issuer and then (maybe) get back money (interest + principal))
Thanks Leli for helping explain, much appreciated So the credit risk of a CDS is born by buyer (that seller fails to payout in case of event happening), where as credit risk in CLN is born by seller and is defined as failure of buyer/issuer to return principal in surplus of payout agreed (in case of event or maturity)+failure to pay scheduled interest. Am I right?
Yes i think it's that, but i'm just a little Part II candidate Maybe David should confirm too. Just be careful "buyer of protection - issuer of note", or buyer of note - seller of protection Leli
CLN are def a tough subject, one in which I don't fully understand either. For the CDS, there are a few layers of credit risk. The CDS seller(insurer) has credit risk that the underlying will trigger a credit event. The CDS buyer(insured) has credit risk that the seller(insurer) will be able to make the payout if of a credit event occurs (ignoring fact you don't need an insurable interest to enter into the CDS!) For the CLN - the issuer of the CLN (which originally held the risky credits) is transferring their credit risk into the CLN. Investors/buyers of the CLN assume the credit risk away for the CLN and issuer. The buyers are compensated for assuming this credit risk via a higher coupon than they might get elsewhere. Think this is correct, hoping not to see much 'testability' on the CLN though. I haven't seen many practice questions on them at least.
Hi Hend, Sorry I'm late to this thread. I think Leli's summary is excellent. In case it helps, below is diagram from our notes/video, which is just stolen from assigned Culp (although I attached, below the Culp image, the CLN diagrams we used prior to Culp, based on Meissner). Key points: CLN ~= funded CDS; i.e., in both cases, "investors" sell credit protection on a reference. But CDS is unfunded (earning yield purely for default/deterioration risk), whereas CLN is funded with investor principal (earning yield for default/deterioration risk + financing/use of funds). CLN "is economically equivalent from the issuer's perspective to issuing a normal note plus buying credit protection from the bond investor through a CDS" (Culp) CLN issuer (aka, protection buyer) = short bond + long CDS; and CLN investor (aka, CLN buyer) = long bond + short CDS. Risk transfer (key difference): unfunded CDS buyer is exposed to counterparty risk and associated wrong-way risk (adverse correlation between reference and counterparty). However, the CLN is FUNDED so the issuer/protection buyer has virtually no counterparty risk. Instead, the CLN buyer has the counterparty risk! (i.e., like any bond buyer, issuer can default on P&I). So, FUNDING is the big difference: the counterparty risk switches from protection buyer to protection seller (CLN investor/CLN buyer) who ought to be compensated with additional premium (versus otherwise equivalent CDS) due to fact that funded principal at risk. Terminology-wise, you can see it looks to be: protection buyer/CLN issuer versus CLN buyer/CLN investor. As i *think* the CLN would be a security, as opposed to CDS derivative, it makes sense to me that CLN investor is a "buyer" not merely a "protection seller" because the CLN investor is purchasing issued securities. (I *think* we have a security/derivative distinction due to the funding, but not 100% sure about that).
why the protection buyer = CLN issuer ? are they same entity? I thought CLN issuer was protection seller sell CDS to protection buyer, then give protection buyers' CDS premium to CLN investor + riskless coupon = enchanced coupon, is this right? or I have to understand another way, that CLN issuer transfer CDS risk to CLN buyer, then CLN issuer can be interpreted as protection buyer. CLN buyer = protection seller
