Starting with credit risky products in general. So, Financial risky analytics have what we call credit exposure. Loans, bonds, interest rate swaps are the main categories of products. These are all agreements for transfer between two counterparties where one or both of the counterparties can default on their obligations under this credit agreement. By far the largest class of credit risky products are interest rate swaps, and there's a notional amount traded on interest rate swaps of around 400 trillion notional at the moment.

So, the idea of an interest rate swap between two counterparties, A and B, is that they each have obligations. A has an obligation to pay B a fixed rate, R percent, on some notional amount. In this case, in this diagram, it's 100 million euros notional, but it could be 10 billion dollars. As I said, 400 trillion notional is outstanding on interest rate swaps, at least actually more. Anyway, on that same notion, the obligation B has is to pay A a floating rate, which I'll call little r i because it changes over time. This fixed rate is fixed at the start of the swap, and the swap has a definite maturity and a schedule for these payments, for example, once a month or once a quarter. The next floating rate is fixed, and then it gets fixed after the payment. It gets fixed again, so the floating rate will change through the life of the swap. Usually, the floating rates are linked to LIBOR; they're what we call LIBOR plus a spread. The spread will depend on the credit risk of B. The more risky that B is, the more likely it is to default. The higher the interest rate above LIBOR that they need to pay.

So, I'm going to first of all look at those interest rate swaps in some detail, and then I'll look at types of credit risk, credit ratings, credit derivatives, and credit files. As I said, I probably will break this into many short videos because it's quite a long section. Interest rate swaps: two counterparties, typically a bank and a company, enter into an IRS (interest rate swap). It doesn't have to be fixed for floating, but most of them are. It could be floating for floating or even fixed for fixed, but that's unlikely. It's much more likely to be fixed for floating on some notional amounts. Then, the swap goes on to a certain maturity, and the payments are at these times: i 1, 2, 3, up to n. Those are the indexing of the payments over time until the maturity, and the swap stops.

As I said, floating payments are typically linked to LIBOR plus a spread. The swap rate at the beginning, this capital R, is called the swap rate. This is fixed so that with the expected floating rates, as the forward LIBOR curve tells us as of the time the swap is started, there'll be a forward LIBOR curve telling us expected LIBOR rates. Maybe the payments are every three months, so you'd look at a three-month LIBOR every time. Look at the three-month LIBOR today so you know exactly what the first floating rate payment is. Then, in three months' time, your expected payment will be what the forward three-month LIBOR rate is as you see it today. Of course, when you get there, it may not be what you expect it to be today, but it will be reset at the actual amount that it is three months from today. Anyway, this is how you make your floating payments. The net present value of all the cash flows, all the fixed payments, and then the received floating payments using the forward LIBOR curve as it is today are set equal to each other. That's the way that you find that R percent so that those two floating and fixed rate payments are the same in net present value terms.

So, swap rates are reset periodically. They could be reset every six months, and each time the floating rate will be based on the six-month LIBOR, as I said, already explained all that. Now let's have a look at a little bit of a diversion, but it's not really. Let's look at cash accounting. I've mentioned this before right at the beginning in the introductory section, the overview of this module.

Company audits for operational analytics are typically based on cash accounting, and in cash accounting, future cash flows are not discounted using a floating rate. In fact, what we want is a known outgoing. For example, the corporate treasury of Shell may have accounts where it's got, I'm not sure it would have loans, but it's such a big company nowadays, you know it might need loans from the government. Even General Motors has got a three trillion credit line from the U.S. government at the moment that it can take out in loans for the next three years. Three trillion dollars. Anyway, so maybe Shell would have loans, but it's nice if they have fixed interest rates on those loans so the accountants can come in to audit their books and they know they've got this amount of loan, you know, one billion dollars or something. They know that they have to make these payments over the next three years. They know exactly how much they are if it's a fixed rate, so then they can be provisioned for in the accounts. They're not regarded as being very risky by the accountants that go into these companies. But floating rates, I mean at the moment floating interest rates are very, very low. They're just half a percent. Also, the base Fed funds rates or the Bank of England base rate, it's like a quarter of a percent or something like that. Obviously, LIBOR rates can be more than that depending on the banks that are making loans to each other, and it would always be above the government base rate. But still, LIBOR rates are really, really small, and of course, then you have the spread on top of that. So, if Shell is a triple B rated company, then it won't pay the LIBOR rate, it would pay something with the spread on top of that. That spread could change as well, but once something is fixed with a spread over LIBOR, the only thing that we know will change is the LIBOR rate, which will fluctuate as the base rate is changed by monetary policy by the Bank of England or any other central bank. It could be, who knows, interest rates could go negative or they could go very positive. I remember a time not so long ago, probably before you were born, but interest rates base rates went up over 10 or 11 percent. They were really, really high. They could go very high again, and I know that many governments are hoping for high-interest rates because that's the way that you could create a sort of inflation that will deflate the amount of government borrowing that they need to pay back in the future.

Anyway, so floating rates cash flows are regarded as risky by companies because there's an uncertainty about how much they have to pay on their loans in the future, for example. But banks use mark-to-market accounting. Now, mark-to-market accounting was actually banned after the Great Depression because it was thought of as being a way of falsely valuing companies by looking at their value in the market. Like, General Motors shares look like they're doing really, really well, but if you look at the book value of General Motors, it's one of these zombie companies. But looking at the mark-to-market on the Bloomberg screen can give you a very false impression. But banks started to use that again during the 1960s and 70s, even though it was banned. Then George Bush actually allowed them formally to use mark-to-market accounting. So in mark-to-market accounting, future cash flows are discounted at a rate that is linked to LIBOR, some LIBOR plus spread. The spread you use depends on whether cash flows are coming from whether that counterparty is likely to default or not. The higher the likelihood of default, the higher the spread those cash flows should be discounted at. So the only risk factor for floating rate cash flows is the amount that's based on spreads. For example, if you're paying a floating rate, which is LIBOR plus spread rate one, this determines what your cash flow amounts are, but then you're discounting using LIBOR plus others, the same spread rate or different spread rate that determines your discount rate. Then the only difference you account and you discount, the only difference is the difference between spread rate one and spread rate two because the LIBOR will cancel out. That's for some fixed maturity. So, LIBOR at three months plus a spread discounted using LIBOR at three months, it's different spread. So under mark-to-market accounting, it's not floating cash flows that are risky, it's fixed cash flows that are more risky. So banks and corporates have got different incentives. Corporates like to have fixed-rate loans, but banks like to give floating-rate loans. This is what drives that interest rate swap market. As I said, more than 400 trillion dollars notional is traded on interest rate swaps and has been for many years. 

So the loan desk of a bank will make floating-rate loans. Companies prefer fixed-rate loans. So if I'm a company and I've got a loan where I've been given a floating rate, I want to actually pay a fixed rate. How do I do that? Well, I'll enter into an interest rate swap agreement with another counterparty. It could actually be the swaps desk of the same bank, you know. So Santander may give me a floating rate loan, and then I go to the swaps desk in Santander and I swap that floating rate for a fixed rate. So I pay fixed and I receive floating, and then I pay the floating to the loan desk.

So, here's another diagram. Suppose you've got a company who gets an eight-year loan from bank A, and it has to pay a floating rate, say LIBOR plus one percent. Then it'll go into an eight-year interest rate swap with another bank or, as I said, it could be a different

 desk in the same bank, and in that interest rate swap it will pay a fixed rate. So this way, what does it do? It receives a floating rate from this bank, LIBOR plus one percent, so this floating rate exactly matches the floating rate payments on the loan. So the fixed rate payments the company makes, it pays those to the swaps desk, and now it's effectively made this loan into a fixed-rate loan.

Banks are happy, and the companies are happy. Banks have floating rate loans; companies have fixed rate loans. Swaps desks typically have to deal with other swaps desks, and they just net things out. Then they look at the overall exposure, and then if the overall exposure is too much, they enter into a deal with another bank, so the banks net off their exposures. So banks trade with each other in the swaps market, and this creates what we call an interest rate swap curve. So as of today, July 25th, 2024, there will be an interest rate swap curve telling you what the swap rates are for one year, for two years, three years, five years, ten years, even 20 years. So there is a swap curve and that's the swap curve.

Now, for the swaps curve, it's normally quoted against what we call a vanilla product. In Europe, vanilla means the EURIBOR market. EURIBOR is like LIBOR but just for Europe. You can think of it as LIBOR for Europe. But then, there are variations on this. So some companies have complicated variations where you have swaps on other things, not just interest rate swaps, but it's just an aside.

Okay, now let's get back to the idea of what credit exposure is. In this example, we've got a floating rate loan with bank A. The company is paying a floating rate, and then it enters into a swap with bank B, and it pays a fixed rate and receives a floating rate. So the company is neutral. But what about bank A? Bank A has received the floating rate loan payments. That's happy. It's making its money that way. What about bank B? Bank B has received fixed rate payments. It's paying a floating rate. So bank B has a credit exposure to the floating rate. The credit exposure to bank B is actually the sum of the exposure to the floating rate plus any other fixed rate it may have. If the floating rate is lower than the fixed rate, bank B is exposed to the amount of that difference. If the floating rate is higher, then bank B is actually exposed in a positive sense.

What about the credit risk to the company? The company has exposure to bank A because it's got this loan, and it has exposure to bank B because it's entered into this interest rate swap. So it's got exposure in both directions. So that's the idea of credit exposure for an interest rate swap. There are credit exposures for loans, for bonds, for different products, and all of these products have different credit exposures.