Understanding Credit Derivatives and Related Instruments First Edition by Antulio Bomfim ISBN 0121082652 978-0121082659
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ISBN 10: 0121082652
ISBN 13: 978-0121082659
Author: Antulio N. Bomfim
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
Table of contents:
I Credit Derivatives: Definition, Market, Uses
1 Credit Derivatives: A Brief Overview
1.1 What are Credit Derivatives?
1.2 Potential “Gains from Trade”
1.3 Types of Credit Derivatives
1.3.1 Single-Name Instruments
1.3.2 Multi-Name Instruments
1.3.3 Credit-Linked Notes
1.3.4 Sovereign vs. Other Reference Entities
1.4 Valuation Principles.
1.4.1 Fundamental Factors
1.4.2 Other Potential Risk Factors
1.4.3 Static Replication vs. Modeling
1.4.4 A Note on Supply, Demand, and Market Frictions
1.5 Counterparty Credit Risk (Again)
2 The Credit Derivatives Market
2.1 Evolution and Size of the Market.
2.2 Market Activity and Size by Instrument Type
2.2.1 Single- vs. Multi-name Instruments
2.2.2 Sovereign vs. Other Reference Entities
2.2.3 Credit Quality of Reference Entities
2.2.4 Maturities of Most Commonly Negotiated Contracts
2.3 Main Market Participants..
2.3.1 Buyers and Sellers of Credit Protection
2.4 Common Market Practices
2.4.1 A First Look at Documentation Issues
2.4.2 Collateralization and Netting
3 Main Uses of Credit Derivatives
3.1 Credit Risk Management by Banks
3.2 Managing Bank Regulatory Capital
3.2.1 A Brief Digression: The 1988 Basle Accord
3.2.2 Credit Derivatives and Regulatory Capital Management
3.3 Yield Enhancement, Portfolio Diversification
3.3.1 Leveraging Credit Exposure, Unfunded Instruments
3.3.2 Synthesizing Long Positions in Corporate Debt
3.4 Shorting Corporate Bonds
3.5 Other Uses of Credit Derivatives
3.5.1 Hedging Vendor-financed Deals
3.5.2 Hedging by Convertible Bond Investors
3.5.3 Selling Protection as an Alternative to Loan Origination
3.6 Credit Derivatives as Market Indicators
II Main Types of Credit Derivatives
4 Floating-Rate Notes
4.1 Not a Credit Derivative
4.2 How Does It Work?
4.3 Common Uses
4.4 Valuation Considerations
5 Asset Swaps
5.1 A Borderline Credit Derivative
5.2 How Does It Work?
5.3 Common Uses
5.4 Valuation Considerations
5.4.1 Valuing the Two Pieces of an Asset Swap
5.4.2 Comparison to Par Floaters.
6 Credit Default Swaps
6.1 How Does It Work?
6.2 Common Uses
6.2.1 Protection Buyers
6.2.2 Protection Sellers
6.2.3 Some Additional Examples
6.3 Valuation Considerations
6.3.1 CDS vs. Cash Spreads in Practice
6.3.2 A Closer Look at the CDS-Cash Basis
6.3.3 When Cash Spreads are Unavailable…
6.4 Variations on the Basic Structure
7 Total Return Swaps
7.1 How Does It Work?
7.2 Common Uses
7.3 Valuation Considerations
7.4 Variations on the Basic Structure
8 Spread and Bond Options
8.1 How Does It Work?
8.2 Common Uses
8.3 Valuation Considerations
8.4 Variations on Basic Structures
9 Basket Default Swaps
9.1 How Does It Work?
9.2 Common Uses
9.3 Valuation Considerations
9.3.1 A First Look at Default Correlation
9.4 Variations on the Basic Structure
10 Portfolio Default Swaps
10.1 How Does It Work?
10.2 Common Uses
10.3 Valuation Considerations
10.3.1 A First Look at the Loss Distribution Function
10.3.2 Loss Distribution and Default Correlation
10.4 Variations on the Basic Structure
11 Principal-Protected Structures
11.1 How Does It Work?
11.2 Common Uses
11.3 Valuation Considerations
11.4 Variations on the Basic Structure
12 Credit-Linked Notes.
12.1 How Does It Work?
12.2 Common Uses
12.3 Valuation Considerations
12.4 Variations on the Basic Structure
13 Repackaging Vehicles
13.1 How Does It Work?
13.2 Why Use Repackaging Vehicles?
13.3 Valuation Considerations
13.4 Variations on the Basic Structure
14 Synthetic CDOs
14.1 Traditional CDOS
14.1.1 How Does It Work?
14.1.2 Common Uses: Balance-sheet and Arbitrage CDOS
14.1.3 Valuation Considerations
14.2 Synthetic Securitization
14.2.1 Common Uses: Why Go Synthetic?
14.2.2 Valuation Considerations for Synthetic CDOS.
14.2.3 Variations on the Basic Structure
III Introduction to Credit Modeling I:
Single-Name Defaults
15 Valuing Defaultable Bonds
15.1 Zero-coupon Bonds
15.2 Risk-neutral Valuation and Probability
15.2.1 Risk-neutral Probabilities
15.3 Coupon-paying Bonds.
15.4 Nonzero Recovery
15.5 Risky Bond Spreads
15.6 Recovery Rates
16 The Credit Curve
16.1 CDS-implied Credit Curves
16.1.1 Implied Survival Probabilities
16.1.2 Examples..
16.1.3 Flat CDS Curve Assumption
16.1.4 A Simple Rule of Thumb
16.1.5 Sensitivity to Recovery Rate Assumptions
16.2 Marking to Market a CDS Position
16.3 Valuing a Principal-protected Note.
16.3.1 Examples.
16.3.2 PPNs vs. Vanilla Notes
16.4 Other Applications and Some Caveats
17 Main Credit Modeling Approaches.
17.1 Structural Approach
17.1.1 The Black-Scholes-Merton Model
17.1.2 Solving the Black-Scholes-Merton Model
17.1.3 Practical Implementation of the Model
17.1.4 Extensions and Empirical Validation
17.1.5 Credit Default Swap Valuation
17.2 Reduced-form Approach
17.2.1 Overview of Some Important Concepts.
17.2.1.1 Stochastic Interest Rates.
17.2.1.2 Forward Default Probabilities
17.2.1.3 Forward Default Rates
17.2.2 Default Intensity.
17.2.3 Uncertain Time of Default
17.2.4 Valuing Defaultable Bonds
17.2.4.1 Nonzero Recovery
17.2.4.2 Alternative Recovery Assumptions
17.2.5 Extensions and Uses of Reduced-form Models
17.2.6 Credit Default Swap Valuation
17.3 Comparing the Two Main Approaches
17.4 Ratings-based Models
18 Valuing Credit Options.
18.1 Forward-starting Contracts
18.1.1 Valuing a Forward-starting CDS
18.1.2 Other Forward-starting Structures
18.2 Valuing Credit Default Swaptions
18.3 Valuing Other Credit Options
18.4 Alternative Valuation Approaches
18.5 Valuing Bond Options.
IV Introduction to Credit Modeling II: Portfolio Credit Risk
19 The Basics of Portfolio Credit Risk
19.1 Default Correlation
19.1.1 Pairwise Default Correlation
19.1.2 Modeling Default Correlation
19.1.3 Pairwise Default Correlation and “3”
19.2 The Loss Distribution Function
19.2.1 Conditional Loss Distribution Function
19.2.2 Unconditional Loss Distribution Function
19.2.3 Large-Portfolio Approximation
19.3 Default Correlation and Loss Distribution
19.4 Monte Carlo Simulation: Brief Overview
19.4.1 How Accurate is the Simulation-Based Method?
19.4.2 Evaluating the Large-Portfolio Method
19.5 Conditional vs. Unconditional Loss Distributions
19.6 Extensions and Alternative Approaches
20 Valuing Basket Default Swaps.
20.1 Basic Features of Basket Swaps..
20.2 Reexamining the Two-Asset FTD Basket
20.3 FTD Basket with Several Reference Entities
20.3.1 A Simple Numerical Example..
20.3.2 A More Realistic Valuation Exercise
20.4 The Second-to-Default Basket
20.5 Basket Valuation and Asset Correlation
20.6 Extensions and Alternative Approaches
21 Valuing Portfolio Swaps and CDOs
21.1 A Simple Numerical Example.
21.2 Model-based Valuation Exercise
21.3 The Effects of Asset Correlation
21.4 The Large-Portfolio Approximation
21.5 Valuing CDOs: Some Basic Insights
21.5.1 Special Considerations for CDO Valuation
21.6 Concluding Remarks
22 A Quick Tour of Commercial Models
22.1 CreditMetrics
22.2 The KMV Framework
22.3 Credit Risk+
22.4 Moody’s Binomial Expansion Technique
22.5 Concluding Remarks
23 Modeling Counterparty Credit Risk
23.1 The Single-Name CDS as a “Two-Asset Portfolio”
23.2 The Basic Model
23.3 A CDS with No Counterparty Credit Risk
23.4 A CDS with Counterparty Credit Risk
23.4.1 Analytical Derivation of Joint
Probabilities of Default
23.4.2 Simulation-based Approach
23.4.3 An Example
23.5 Other Models and Approaches
23.6 Counterparty Credit Risk in Multi-name Structures
23.7 Concluding Thoughts
V A Brief Overview of Documentation and Regulatory Issues
24 Anatomy of a CDS Transaction..
24.1 Standardization of CDS Documentation
24.1.1 Essential Terms of a CDS Transaction
24.1.1.1 The Reference Entity
24.1.1.2 Reference and Deliverable Obligations
24.1.1.3 Settlement Method
24.1.1.4 Credit Events.
24.1.2 Other Important Details of a CDS Transaction
24.1.3 A Few Words of Caution
24.2 When a Credit Event Takes Place…
24.2.1 Credit Event Notification and Verification
24.2.2 Settling the Contract
24.3 The Restructuring Debate
24.3.1 A Case in Point: Conseco
24.3.2 Modified Restructuring
24.3.3 A Bifurcated Market
24.4 Valuing the Restructuring Clause
24.4.1 Implications for Implied Survival Probabilities
25 A Primer on Bank Regulatory Issues
25.1 The Basel II Capital Accord
25.2 Basel II Risk Weights and Credit Derivatives
25.3 Suggestions for Further Reading
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