Understanding Credit Derivatives and Related Instruments,

Part 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 Diversi_cation
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-_nanced 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

Part 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 129
10.1 How Does It Work?
10.2 Common Uses
10.3 Valuation Considerations
10.3.1 A _rst 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 161
14.1 Traditional CDOs
14.1.1 How Does it Work?
14.1.2 Common Uses
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 Uncertain Time of Default
17.2.3 Default Intensity
17.2.4 Pricing Defaultable Bonds
17.2.4.1 Non-zero 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 of 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 \_""
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 Other Approaches to Portfolio Credit Risk Modeling
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 E_ects 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 CreditRisk+
22.4 Moody’s Binomial Expansion Technique
22.5 Intensity-based Models
22.6 Concluding Thoughts
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 Multiname Structures
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
24.2 When a Credit Event Takes Place
24.2.1 Credit event noti_cation and veri_cation
24.2.2 Settling the contract
24.3 The Restructuring Debate
24.3.1 A case in point: Conseco
24.3.2 Modi_ed 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
Appendix A Basic Concepts from Bond Math
A.1 Zero-coupon Bonds
A.2 Compounding
A.3 Zero-coupon Bond Prices as Discount Factors
A.4 Coupon-paying Bonds
A.5 Inferring Zero-coupon Yields from the Coupon Curve
A.6 Forward Rates
A.7 Forward Interest Rates and Bond Prices
Appendix B Basic Concepts from Statistics
B.1 Probability Density Function: Discrete Case
B.2 Cumulative Distribution Function
B.3 Probability Density Function: Continuous Case
B.4 Expected Value and Variance
B.5 Bernoulli Trials and the Bernoulli Distribution
B.6 The Binomial Distribution
B.7 The Poisson and Exponential Distributions
B.8 The Normal Distribution
B.9 The Lognormal Distribution
B.10 Joint Probability Distributions
B.11 Independence
B.12 The Bivariate Normal Distribution