Hypothetical simulations of credit derivatives

To simulate securitisation process and credit derivatives, some simple hypothetical examples can be described in the forms of personal loans.

Scenario 1: with XXX

Ten students borrow $100 each at $15 interest from AAA. If the ten students pay back all of their debts, AAA will receive $1000 plus $150 interest, totalling $1150. Knowing that AAA would have the $1150 at the end, he then asks XXX who has many friends to find some people who want to lend AAA some money. XXX finally finds 80 friends with $1 interest for $10 each and 20 friends with $2 interests for $10 each. Friends who choose the $1 interest will be paid first after those taking $2 interest if any of the students default. If not default, AAA would earn $30 (may be shared with XXX) from $150 interest deducted by $120 and the 80 friends would earn $1 each and the 20 friends US$2 each. If 2 students default, AAA would still earn $30 but the 80 friends with $1 interest would have to wait longer to get their $10 back.

Scenario 2: with QQQ

Other way to show a protection motive would be like this. AAA knows that there is a risk of the ten students not paying back the debts. The ten students would pay back the interest, but may not pay back some part of their debts. AAA then finds a special friend QQQ. QQQ asks AAA to pay $100 in advance as promising to cover any loss AAA gets at the end. QQQ may expect that AAA might just get $925 back of $1000 as paying the rest of $75 to AAA. If the ten students just pay $925 back, AAA still gets $1000. However, AAA’s $150 income is to be deducted by $100 protection cost from QQQ who has promised to cover the loss, totalling $50. Meanwhile, QQQ would receive $100 from AAA and pays $75 to cover AAA’s , earning $25 in total. If the ten students pay back all of the $1000, AAA’s earning would be still $50 and QQQ’s earning would be $100 without covering any loss. How about if the ten students just pay $700 back of $1000? QQQ may simultaneously buy protection at $50 from GGG who promises to cover the loss until $300. QQQ would earn $50 if default or not default whilst GGG would earn $50 if not default and lose maximum $250 if default.

Scenario 3: with HHH

Another instant way to alter the risk of default can be shown as another friend HHH pays AAA $100 now and $1000 at the end whatever the situation would be as AAA has to pass all of US$1150 at the end. AAA would get an instant profit of US$100 now and HHH would get a profit of US$50 at the end if the ten students do not default. To cover the loss if the ten students default, HHH may buy protection from GGG at US$30 to protect the loss until US$150. HHH would earn US$20 whether default or not and GGG would earn US$30 if not default and lose maximum US$120 if default.

Scenario 4: GGG as a dealer

The last two simulations shows that the price of GGG’s protection may vary based on the probability of default of the students’ debts over time. To some extent, the premium $50 for $300 is still reasonable. If the default probability decreases, it may apply premiums from $40 for $200 loss, $30 for $150 loss, $20 for $100 loss until $10 for $50 loss. Therefore, it can be set protection prices referred to the value of $1000 students’ debts would default from $50 to $10. As a dealer, GGG may trade the protection with some counterparties. One may buy GGG protection for the students’ debts at $20 for $100 default and sell it back to GGG at $40 once the students’ debts are getting riskier to $200 default, earning $20 in total.

GGG now holds protection $40 for $200 default. Believing that the students’ debts would default maximum $100, GGG then may end up buying protection from ZZZ at $20 premium for $100 loss. If not default, GGG would receive $40 from QQQ and pays ZZZ $20, earning $20. If default by $100, GGG’s earning is still $20 and ZZZ would face a maximum loss of $80.