Elsevier S & T

Understanding Credit Derivatives and Related Instruments

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Table of contents
  • Contentsvii
  • Part I Credit Derivatives: Definition, Market, Uses1
  • 1 Credit Derivatives: A Brief Overview3
  • 1.1 What are Credit Derivatives?3
  • 1.2 Potential Gains from TradeŽ5
  • 1.3 Types of Credit Derivatives6
  • 1.3.1 Single-Name Instruments6
  • 1.3.2 Multi-Name Instruments7
  • 1.3.3 Credit-Linked Notes8
  • 1.3.4 Sovereign vs. Other Reference Entities8
  • 1.4 Valuation Principles9
  • 1.4.1 Fundamental Factors10
  • 1.4.2 Other Potential Risk Factors11
  • 1.4.3 Static Replication vs. Modeling12
  • 1.4.4 A Note on Supply, Demand, and Market Frictions14
  • 1.5 Counterparty Credit Risk (Again)15
  • 2 The Credit Derivatives Market17
  • 2.1 Evolution and Size of the Market18
  • 2.2 Market Activity and Size by Instrument Type19
  • 2.2.1 Single- vs. Multi-name Instruments20
  • 2.2.2 Sovereign vs. Other Reference Entities21
  • 2.2.3 Credit Quality of Reference Entities21
  • 2.2.4 Maturities of Most Commonly Negotiated Contracts23
  • 2.3 Main Market Participants23
  • 2.3.1 Buyers and Sellers of Credit Protection24
  • 2.4 Common Market Practices25
  • 2.4.1 A First Look at Documentation Issues26
  • 2.4.2 Collateralization and Netting27
  • 3 Main Uses of Credit Derivatives29
  • 3.1 Credit Risk Management by Banks29
  • 3.2 Managing Bank Regulatory Capital31
  • 3.2.1 A Brief Digression: The 1988 Basle Accord31
  • 3.2.2 Credit Derivatives and Regulatory Capital Management33
  • 3.3 Yield Enhancement, Portfolio Diversi.cation35
  • 3.3.1 Leveraging Credit Exposure, Unfunded Instruments35
  • 3.3.2 Synthesizing Long Positions in Corporate Debt36
  • 3.4 Shorting Corporate Bonds37
  • 3.5 Other Uses of Credit Derivatives38
  • 3.5.1 Hedging Vendor-.nanced Deals38
  • 3.5.2 Hedging by Convertible Bond Investors38
  • 3.5.3 Selling Protection as an Alternative to Loan Origination39
  • 3.6 Credit Derivatives as Market Indicators39
  • Part II Main Types of Credit Derivatives41
  • 4 Floating-Rate Notes43
  • 4.1 Not a Credit Derivative...43
  • 4.2 How Does It Work?43
  • 4.3 Common Uses45
  • 4.4 Valuation Considerations45
  • 5 Asset Swaps53
  • 5.1 A Borderline Credit Derivative...53
  • 5.2 How Does It Work?54
  • 5.3 Common Uses56
  • 5.4 Valuation Considerations58
  • 5.4.1 Valuing the Two Pieces of an Asset Swap59
  • 5.4.2 Comparison to Par Floaters62
  • 6 Credit Default Swaps67
  • 6.1 How Does It Work?68
  • 6.2 Common Uses70
  • 6.2.1 Protection Buyers70
  • 6.2.2 Protection Sellers71
  • 6.2.3 Some Additional Examples72
  • 6.3 Valuation Considerations73
  • 6.3.1 CDS vs. Cash Spreads in Practice76
  • 6.3.2 A Closer Look at the CDS-Cash Basis78
  • 6.3.3 When Cash Spreads are Unavailable...80
  • 6.4 Variations on the Basic Structure82
  • 7 Total Return Swaps83
  • 7.1 How Does It Work?83
  • 7.2 Common Uses85
  • 7.3 Valuation Considerations87
  • 7.4 Variations on the Basic Structure89
  • 8 Spread and Bond Options91
  • 8.1 How Does It Work?91
  • 8.2 Common Uses93
  • 8.3 Valuation Considerations95
  • 8.4 Variations on Basic Structures96
  • 9 Basket Default Swaps99
  • 9.1 How Does It Work?99
  • 9.2 Common Uses101
  • 9.3 Valuation Considerations101
  • 9.3.1 A First Look at Default Correlation104
  • 9.4 Variations on the Basic Structure105
  • 10 Portfolio Default Swaps107
  • 10.1 How Does It Work?107
  • 10.2 Common Uses110
  • 10.3 Valuation Considerations110
  • 10.3.1 A First Look at the Loss Distribution Function111
  • 10.3.2 Loss Distribution and Default Correlation113
  • 10.4 Variations on the Basic Structure116
  • 11 Principal-Protected Structures117
  • 11.1 How Does It Work?117
  • 11.2 Common Uses119
  • 11.3 Valuation Considerations119
  • 11.4 Variations on the Basic Structure122
  • 12 Credit-Linked Notes123
  • 12.1 How Does It Work?123
  • 12.2 Common Uses125
  • 12.3 Valuation Considerations126
  • 12.4 Variations on the Basic Structure126
  • 13 Repackaging Vehicles127
  • 13.1 How Does It Work?127
  • 13.2 Why Use Repackaging Vehicles?129
  • 13.3 Valuation Considerations130
  • 13.4 Variations on the Basic Structure130
  • 14 Synthetic CDOs133
  • 14.1 Traditional CDOs133
  • 14.1.1 How Does It Work?134
  • 14.1.2 Common Uses: Balance-sheet and Arbitrage CDOs136
  • 14.1.3 Valuation Considerations137
  • 14.2 Synthetic Securitization137
  • 14.2.1 Common Uses: Why Go Synthetic?139
  • 14.2.2 Valuation Considerations for Synthetic CDOs140
  • 14.2.3 Variations on the Basic Structure140
  • Part III Introduction to Credit Modeling I: Single-Name Defaults143
  • 15 Valuing Defaultable Bonds145
  • 15.1 Zero-coupon Bonds145
  • 15.2 Risk-neutral Valuation and Probability147
  • 15.2.1 Risk-neutral Probabilities149
  • 15.3 Coupon-paying Bonds150
  • 15.4 Nonzero Recovery152
  • 15.5 Risky Bond Spreads153
  • 15.6 Recovery Rates154
  • 16 The Credit Curve157
  • 16.1 CDS-implied Credit Curves158
  • 16.1.1 Implied Survival Probabilities159
  • 16.1.2 Examples161
  • 16.1.3 Flat CDS Curve Assumption162
  • 16.1.4 A Simple Rule of Thumb163
  • 16.1.5 Sensitivity to Recovery Rate Assumptions164
  • 16.2 Marking to Market a CDS Position164
  • 16.3 Valuing a Principal-protected Note166
  • 16.3.1 Examples167
  • 16.3.2 PPNs vs.Vanilla Notes168
  • 16.4 Other Applications and Some Caveats169
  • 17 Main Credit Modeling Approaches171
  • 17.1 Structural Approach172
  • 17.1.1 The Black-Scholes-Merton Model172
  • 17.1.2 Solving the Black-Scholes-Merton Model176
  • 17.1.3 Practical Implementation of the Model178
  • 17.1.4 Extensions and Empirical Validation178
  • 17.1.5 Credit Default Swap Valuation181
  • 17.2 Reduced-form Approach183
  • 17.2.1 Overview of Some Important Concepts183
  • 17.2.1.1 Stochastic Interest Rates184
  • 17.2.1.2 Forward Default Probabilities185
  • 17.2.1.3 Forward Default Rates186
  • 17.2.2 Default Intensity188
  • 17.2.3 Uncertain Time of Default190
  • 17.2.4 Valuing Defaultable Bonds191
  • 17.2.4.1 Non zero Recovery192
  • 17.2.4.2 Alternative Recovery Assumptions193
  • 17.2.5 Extensions and Uses of Reduced-form Models196
  • 17.2.6 Credit Default Swap Valuation197
  • 17.3 Comparing the Two Main Approaches198
  • 17.4 Ratings-based Models200
  • 18 Valuing Credit Options205
  • 18.1 Forward-starting Contracts205
  • 18.1.1 Valuing a Forward-starting CDS206
  • 18.1.2 Other Forward-starting Structures207
  • 18.2 Valuing Credit Default Swaptions208
  • 18.3 Valuing Other Credit Options210
  • 18.4 Alternative Valuation Approaches211
  • 18.5 Valuing Bond Options211
  • Part IV Introduction to Credit Modeling II: Portfolio Credit Risk213
  • 19 The Basics of Portfolio Credit Risk215
  • 19.1 Default Correlation215
  • 19.1.1 Pairwise Default Correlation216
  • 19.1.2 Modeling Default Correlation219
  • 19.1.3 Pairwise Default Correlation and “β”223
  • 19.2 The Loss Distribution Function224
  • 19.2.1 Conditional Loss Distribution Function225
  • 19.2.2 Unconditional Loss Distribution Function226
  • 19.2.3 Large-Portfolio Approximation228
  • 19.3 Default Correlation and Loss Distribution230
  • 19.4 Monte Carlo Simulation: Brief Overview231
  • 19.4.1 How Accurate is the Simulation-Based Method?233
  • 19.4.2 Evaluating the Large-Portfolio Method235
  • 19.5 Conditional vs. Unconditional Loss Distributions237
  • 19.6 Extensions and Alternative Approaches238
  • 20 Valuing Basket Default Swaps239
  • 20.1 Basic Features of Basket Swaps239
  • 20.2 Reexamining the Two-Asset FTD Basket240
  • 20.3 FTD Basket with Several Reference Entities241
  • 20.3.1 A Simple Numerical Example241
  • 20.3.2 A More Realistic Valuation Exercise243
  • 20.4 The Second-to-Default Basket246
  • 20.5 Basket Valuation and Asset Correlation247
  • 20.6 Extensions and Alternative Approaches248
  • 21 Valuing Portfolio Swaps and CDOs249
  • 21.1 A Simple Numerical Example249
  • 21.2 Model-based Valuation Exercise252
  • 21.3 The Effects of Asset Correlation255
  • 21.4 The Large-Portfolio Approximation257
  • 21.5 Valuing CDOs: Some Basic Insights258
  • 21.5.1 Special Considerations for CDO Valuation258
  • 21.6 Concluding Remarks259
  • 22 A Quick Tour of Commercial Models261
  • 22.1 CreditMetrics262
  • 22.2 The KMV Framework262
  • 22.3 CreditRisk+263
  • 22.4 Moody’s Binomial Expansion Technique264
  • 22.5 Concluding Remarks265
  • 23 Modeling Counterparty Credit Risk267
  • 23.1 The Single-Name CDS as a Two-Asset PortfolioŽ268
  • 23.2 The Basic Model268
  • 23.3 A CDS with No Counterparty Credit Risk270
  • 23.4 A CDS with Counterparty Credit Risk272
  • 23.4.1 Analytical Derivation of Joint Probabilities of Default273
  • 23.4.2 Simulation-based Approach277
  • 23.4.3 An Example278
  • 23.5 Other Models and Approaches280
  • 23.6 Counterparty Credit Risk in Multi-name Structures281
  • 23.7 Concluding Thoughts281
  • Part V A Brief Overview of Documentation and Regulatory Issues283
  • 24 Anatomy of a CDS Transaction285
  • 24.1 Standardization of CDS Documentation286
  • 24.1.1 Essential Terms of a CDS Transaction288
  • 24.1.1.1 The Reference Entity288
  • 24.1.1.2 Reference and Deliverable Obligations289
  • 24.1.1.3 Settlement Method289
  • 24.1.1.4 Credit Events289
  • 24.1.2 Other Important Details of a CDS Transaction290
  • 24.1.3 A Few Words of Caution291
  • 24.2 When a Credit Event Takes Place...291
  • 24.2.1 Credit Event Noti.cation and Veri.cation291
  • 24.2.2 Settling the Contract292
  • 24.3 The Restructuring Debate293
  • 24.3.1 A Case in Point: Conseco294
  • 24.3.2 Modi.ed Restructuring295
  • 24.3.3 A Bifurcated Market295
  • 24.4 Valuing the Restructuring Clause296
  • 24.4.1 Implications for Implied Survival Probabilities296
  • 25 A Primer on Bank Regulatory Issues299
  • 25.1 The Basel II Capital Accord300
  • 25.2 Basel II Risk Weights and Credit Derivatives302
  • 25.3 Suggestions for Further Reading303
  • Appendix A Basic Concepts from Bond Math305
  • A.1 Zero-coupon Bonds305
  • A.2 Compounding306
  • A.3 Zero-coupon Bond Prices as Discount Factors307
  • A.4 Coupon-paying Bonds307
  • A.5 Inferring Zero-coupon Yields from the Coupon Curve308
  • A.6 Forward Rates309
  • A.7 Forward Interest Rates and Bond Prices310
  • Appendix B Basic Concepts from Statistics313
  • B.1 Cumulative Distribution Function313
  • B.2 Probability Function314
  • B.3 Probability Density Function314
  • B.4 Expected Value and Variance315
  • B.5 Bernoulli Trials and the Bernoulli Distribution316
  • B.6 The Binomial Distribution316
  • B.7 The Poisson and Exponential Distributions317
  • B.8 The Normal Distribution320
  • B.9 The Lognormal Distribution321
  • B.10 Joint Probability Distributions322
  • B.11 Independence323
  • B.12 The Bivariate Normal Distribution323
  • Bibliography325
  • Index331
Book details
  • Vendor Elsevier S & T
  • SKU 9780121082659
  • ISBN-13 9780080481487

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The global credit derivatives market is estimated to have grown from virtually nothing in the early 1990s to over $2 trillion dollars. Although still relatively young, the credit derivatives market has already developed to the point where one can characterize its evolution in terms of developments in its various segments, such as the market for single-name credit derivatives or the market for credit derivatives written on sovereign credits.

Understanding Credit Derivatives offers a comprehensive introduction to the credit derivatives market. Rather than presenting a highly technical exploration of the subject, it offers intuitive and rigorous summaries of the major subjects and the principal perspectives associated with them. The centerpiece is pricing and valuation issues, especially discussions of different valuation tools and their use in credit models.

* Offers a broad overview of this growing field
* Discusses all the main types of credit derivatives
* Provides back-of-the-book summary of statistics and fixed-income mathematics