Second- and third-loss portfolio default swaps are defined similarly. You can help correct errors and omissions. What else can be done? Some key valuation principles are also highlighted. Second- and third-to-default products are defined in an analogous way. Most debt instruments, such as loans extended by banks or corporate bonds held by investors, can be thought of as baskets that could potentially involve several types of risk. For instance, in a portfolio default swap with a first-loss piece of, say, 10%, protection sellers are exposed to, however, many individual defaults are necessary to lead to a 10% loss in the overall portfolio.
For instance, consider the case where there are no readily observed reliable prices of notes issued by the reference entity. Credit-linked notes can be broadly thought of as regular debt obligations with an embedded credit derivative. Under such circumstances, the lower the post-default value of the defaulted debt—which the protection provider may have to buy for its par value in the event of default—the more expensive the protection. My goal remains to offer a comprehensive introduction to credit derivatives and related instruments. How much should this buyer be willing to pay for obtaining protection against default by the reference entity? For instance, in a substantially rewritten Chapter 2, I discuss the evolution of the market in recent years, documenting stark differences in key market characteristics in the pre- and post-crisis periods, such as the much reduced prevalence of synthetic collateralized debt obligations since the crisis and the growing role of central counterparties.
First, just as one would not buy life insurance from an insurance company that is teetering on the verge of bankruptcy, one should not buy default protection from a credit derivatives dealer with a poor credit standing. Every reader familiar with mid-level mathematics who wants to understand the functioning of the derivatives markets in both practical and academic contexts can fully satisfy his or her interests with the comprehensive assessments in this book. Come up with a pricing methodology that is as foolproof as possible. Let us carry on with the above example. One must venture into the world of credit risk modeling.
Limiting factors for the market for credit derivatives written on sovereign entities include the fact that the investor base for nonsovereign debt is significantly larger than that for sovereign debt. For example, contracts written on sovereign debtors may include moratorium and debt repudiation as credit events events that would trigger the payment by the protection seller , whereas contracts that reference corporate debt generally do not include such events. The discussion that follows focuses on three dimensions: single-name vs. The book's centerpiece is pricing and valuation issues, especially valuation tools and their uses in credit models. Five new chapters cover practices that have become commonplace as a result of the 2008 financial crisis, including standardized premiums and upfront payments.
It should be noted, however, that large discrepancies between prices of credit derivatives and underlying cash instruments are unlikely to persist: Not only are arbitrageurs expected to take advantage of such discrepancies, but also new participants might be enticed to enter the market, reducing the limiting role of market segmentation. A relatively simple example of a multiname credit derivative is the first-to-default basket swap. Holders of that note are also exposed to credit risk, or the risk that the note issuer may default on its obligations. The basic features of the financial contract just described are the main characteristics of one of the most prevalent types of credit derivatives, the credit default swap. The protection seller may itself go bankrupt either before or at the same time as the reference entity. Keywords Single-name credit derivatives Multiname-credit derivatives Valuation principles Static replication Counterparty credit risk Chapter Outline 1. With that in mind, I have updated the discussion in most chapters to keep it consistent with current market trends.
Every reader familiar with mid-level mathematics who wants to understand the functioning of the derivatives markets in both practical and academic contexts can fully satisfy his or her interests with the comprehensive assessments in this book. As simple as the above example is, it provides a powerful rationale for the existence of the expanding market for credit derivatives. The premium is set as a percentage of the total amount of protection bought the notional amount of the contract. In addition, modeling and quantifying credit risk associated with sovereign debtors can be more challenging than doing so for corporate borrowers. Moreover, there are more limited default data for sovereign debtors than for corporations—in part because there are more corporations than countries—which makes it harder to make statistical inferences based on historical experience.
Broadly speaking, the main approaches can be grouped in two main classes: those based on static replication methods and those that rely more heavily on credit risk models. For one, we have lived through the 2008 financial crisis, the most significant period of financial market turmoil since the Great Depression. Another example regards the role of credit-linked notes, discussed in Chapter 12, which greatly facilitate the trading of bank loan risk. Other Reference Entities 8 1. One might say that the answer is simple. With many multiname instruments, creating the replicating portfolio can be difficult in practice, if not impossible.
Five new chapters cover practices that have become commonplace as a result of the 2008 financial crisis, including standardized premiums and upfront payments. Bomfim Much has changed in the global credit derivatives market since the publication of the first edition of this book. Should a default event occur, however, the protection seller becomes liable for the difference between the face value of the debt obligations issued by the reference entity and their recovery value. Nonetheless, some of the features of early credit derivatives contracts, such as the treatment of debt restructurings, mentioned above, would later prove to be less than satisfactory in the eyes of many market participants. As noted below, market participants commonly use credit-enhancement mechanisms—such as the posting of collateral—to mitigate the effects of counterparty credit risk in the dynamics of the credit derivatives market.