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Understanding Credit Derivatives and Related Instruments - 1st Edition - ISBN: 9780121082659, 9780080481487

Understanding Credit Derivatives and Related Instruments

1st Edition

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Authors: Antulio Bomfim Antulio Bomfim
Hardcover ISBN: 9780121082659
eBook ISBN: 9780080481487
Imprint: Academic Press
Published Date: 6th December 2004
Page Count: 368
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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.

Key Features

  • 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


Graduate Students in MBA and specialized finance programs, professionals working with investment tool such as financial analysts and portfolio managers.

Table of Contents

Part I Credit Derivatives: Definition, Market, Uses <BR id=""CRLF""><BR id=""CRLF"">1 Credit Derivatives: A Brief Overview <BR id=""CRLF"">1.1 What are Credit Derivatives?<BR id=""CRLF"">1.2 Potential \Gains from Trade"" <BR id=""CRLF"">1.3 Types of Credit Derivatives <BR id=""CRLF"">1.3.1 Single-Name Instruments <BR id=""CRLF"">1.3.2 Multi-Name Instruments<BR id=""CRLF"">1.3.3 Credit-Linked Notes <BR id=""CRLF"">1.3.4 Sovereign vs. Other Reference Entities <BR id=""CRLF"">1.4 Valuation Principles <BR id=""CRLF"">1.4.1 Fundamental Factors <BR id=""CRLF"">1.4.2 Other Potential Risk Factors<BR id=""CRLF"">1.4.3 Static Replication vs. Modeling<BR id=""CRLF"">1.4.4 A Note on Supply, Demand, and Market Frictions<BR id=""CRLF"">1.5 Counterparty Credit Risk (Again)<BR id=""CRLF""><BR id=""CRLF"">2 The Credit Derivatives Market <BR id=""CRLF"">2.1 Evolution and Size of the Market<BR id=""CRLF"">2.2 Market Activity and Size by Instrument Type<BR id=""CRLF"">2.2.1 Single- vs. Multi-name Instruments <BR id=""CRLF"">2.2.2 Sovereign vs. Other Reference Entities <BR id=""CRLF"">2.2.3 Credit Quality of Reference Entities<BR id=""CRLF"">2.2.4 Maturities of Most Commonly Negotiated Contracts<BR id=""CRLF"">2.3 Main Market Participants<BR id=""CRLF"">2.3.1 Buyers and Sellers of Credit Protection<BR id=""CRLF"">2.4 Common Market Practices <BR id=""CRLF"">2.4.1 A First Look at Documentation Issues <BR id=""CRLF"">2.4.2 Collateralization and Netting <BR id=""CRLF"">3 Main Uses of Credit Derivatives <BR id=""CRLF"">3.1 Credit Risk Management by Banks <BR id=""CRLF"">3.2 Managing Bank Regulatory Capital <BR id=""CRLF"">3.2.1 A Brief Digression: The 1988 Basle Accord <BR id=""CRLF"">3.2.2 Credit Derivatives and Regulatory Capital Management<BR id=""CRLF"">3.3 Yield Enhancement, Portfolio Diversi_cation <BR id=""CRLF"">3.3.1 Leveraging Credit Exposure, Unfunded Instruments<BR id=""CRLF"">3.3.2 Synthesizing Long Positions in Corporate Debt <BR id=""CRLF"">3.4 Shorting Corporate Bonds <BR id=""CRLF"">3.5 Other uses of credit derivatives<BR id=""CRLF"">3.5.1 Hedging Vendor-_nanced Deals <BR id=""CRLF"">3.5.2 Hedging by convertible bond investors <BR id=""CRLF"">3.5.3 Selling Protection as an Alternative to Loan Origination <BR id=""CRLF"">3.6 Credit Derivatives as Market Indicators<BR id=""CRLF""><BR id=""CRLF"">Part II Main Types of Credit Derivatives <BR id=""CRLF"">4 Floating-Rate Notes <BR id=""CRLF"">4.1 Not a Credit Derivative<BR id=""CRLF"">4.2 How Does It Work? <BR id=""CRLF"">4.3 Common Uses <BR id=""CRLF"">4.4 Valuation Considerations<BR id=""CRLF"">5 Asset Swaps <BR id=""CRLF"">5.1 A Borderline Credit Derivative<BR id=""CRLF"">5.2 How Does It Work? <BR id=""CRLF"">5.3 Common Uses <BR id=""CRLF"">5.4 Valuation Considerations <BR id=""CRLF"">5.4.1 Valuing the two pieces of an asset swap <BR id=""CRLF"">5.4.2 Comparison to Par Floaters <BR id=""CRLF"">6 Credit Default Swaps <BR id=""CRLF"">6.1 How Does It Work?<BR id=""CRLF"">6.2 Common Uses <BR id=""CRLF"">6.2.1 Protection Buyers <BR id=""CRLF"">6.2.2 Protection Sellers<BR id=""CRLF"">6.2.3 Some Additional Examples <BR id=""CRLF"">6.3 Valuation Considerations <BR id=""CRLF"">6.3.1 CDS vs. Cash Spreads in Practice <BR id=""CRLF"">6.3.2 A Closer Look at the CDS-Cash Basis <BR id=""CRLF"">6.3.3 When Cash Spreads are Unavailable<BR id=""CRLF"">6.4 Variations on the Basic Structure <BR id=""CRLF"">7 Total Return Swaps <BR id=""CRLF"">7.1 How Does It Work? <BR id=""CRLF"">7.2 Common Uses <BR id=""CRLF"">7.3 Valuation Considerations <BR id=""CRLF"">7.4 Variations on the Basic Structure<BR id=""CRLF"">8 Spread and Bond Options <BR id=""CRLF"">8.1 How Does It Work?<BR id=""CRLF"">8.2 Common Uses<BR id=""CRLF"">8.3 Valuation Considerations <BR id=""CRLF"">8.4 Variations on Basic Structures <BR id=""CRLF"">9 Basket Default Swaps <BR id=""CRLF"">9.1 How Does It Work? <BR id=""CRLF"">9.2 Common Uses <BR id=""CRLF"">9.3 Valuation Considerations<BR id=""CRLF"">9.3.1 A first look at default correlation <BR id=""CRLF"">9.4 Variations on the Basic Structure<BR id=""CRLF"">10 Portfolio Default Swaps 129<BR id=""CRLF"">10.1 How Does It Work? <BR id=""CRLF"">10.2 Common Uses <BR id=""CRLF"">10.3 Valuation Considerations<BR id=""CRLF"">10.3.1 A rst look at the loss distribution function <BR id=""CRLF"">10.3.2 Loss distribution and default correlation <BR id=""CRLF"">10.4 Variations on the Basic Structure <BR id=""CRLF"">11 Principal-Protected Structures <BR id=""CRLF"">11.1 How Does It Work? <BR id=""CRLF"">11.2 Common Uses <BR id=""CRLF"">11.3 Valuation Considerations <BR id=""CRLF"">11.4 Variations on the Basic Structure <BR id=""CRLF"">12 Credit-Linked Notes <BR id=""CRLF"">12.1 How Does It Work? <BR id=""CRLF"">12.2 Common Uses <BR id=""CRLF"">12.3 Valuation Considerations <BR id=""CRLF"">12.4 Variations on the Basic Structure <BR id=""CRLF"">13 Repackaging Vehicles<BR id=""CRLF"">13.1 How Does It Work? <BR id=""CRLF"">13.2 Why Use Repackaging Vehicles?<BR id=""CRLF"">13.3 Valuation Considerations<BR id=""CRLF"">13.4 Variations on the Basic Structure <BR id=""CRLF"">14 Synthetic CDOs 161<BR id=""CRLF"">14.1 Traditional CDOs <BR id=""CRLF"">14.1.1 How Does it Work? <BR id=""CRLF"">14.1.2 Common Uses <BR id=""CRLF"">14.1.3 Valuation Considerations <BR id=""CRLF"">14.2 Synthetic Securitization <BR id=""CRLF"">14.2.1 Common uses: Why go synthetic?<BR id=""CRLF"">14.2.2 Valuation considerations for synthetic CDOs <BR id=""CRLF"">14.2.3 Variations on the Basic Structure<BR id=""CRLF"">III Introduction to Credit Modeling I: Single-Name Defaults <BR id=""CRLF"">15 Valuing Defaultable Bonds <BR id=""CRLF"">15.1 Zero-coupon Bonds <BR id=""CRLF"">15.2 Risk-neutral Valuation and Probability <BR id=""CRLF"">15.2.1 Risk-neutral probabilities<BR id=""CRLF"">15.3 Coupon-paying Bonds<BR id=""CRLF"">15.4 Nonzero Recovery<BR id=""CRLF"">15.5 Risky Bond Spreads <BR id=""CRLF"">15.6 Recovery Rates <BR id=""CRLF"">16 The Credit Curve <BR id=""CRLF"">16.1 CDS-implied Credit Curves<BR id=""CRLF"">16.1.1 Implied Survival Probabilities <BR id=""CRLF"">16.1.2 Examples <BR id=""CRLF"">16.1.3 Flat CDS Curve Assumption <BR id=""CRLF"">16.1.4 A Simple Rule of Thumb <BR id=""CRLF"">16.1.5 Sensitivity to Recovery Rate Assumptions<BR id=""CRLF"">16.2 Marking to Market a CDS Position<BR id=""CRLF"">16.3 Valuing a Principal-protected Note <BR id=""CRLF"">16.3.1 Examples <BR id=""CRLF"">16.3.2 PPNs vs. Vanilla Notes<BR id=""CRLF"">16.4 Other Applications and Some Caveats <BR id=""CRLF"">17 Main Credit Modeling Approaches <BR id=""CRLF"">17.1 Structural Approach <BR id=""CRLF"">17.1.1 The Black-Scholes-Merton Model <BR id=""CRLF"">17.1.2 Solving the Black-Scholes-Merton Model <BR id=""CRLF"">17.1.3 Practical Implementation of the Model <BR id=""CRLF"">17.1.4 Extensions and Empirical Validation <BR id=""CRLF"">17.1.5 Credit Default Swap Valuation<BR id=""CRLF"">17.2 Reduced-Form Approach<BR id=""CRLF"">17.2.1 Overview of Some Important Concepts <BR id=""CRLF""> Stochastic interest rates <BR id=""CRLF""> Forward default probabilities <BR id=""CRLF""> Forward default rates<BR id=""CRLF"">17.2.2 Uncertain Time of Default <BR id=""CRLF"">17.2.3 Default Intensity <BR id=""CRLF"">17.2.4 Pricing Defaultable Bonds <BR id=""CRLF""> Non-zero recovery <BR id=""CRLF""> Alternative recovery assumptions <BR id=""CRLF"">17.2.5 Extensions and Uses of Reduced-form Models <BR id=""CRLF"">17.2.6 Credit Default Swap Valuation <BR id=""CRLF"">17.3 Comparing the Two Main Approaches <BR id=""CRLF"">17.4 Ratings-based Models <BR id=""CRLF"">18 Valuing of Credit Options <BR id=""CRLF"">18.1 Forward-starting contracts <BR id=""CRLF"">18.1.1 Valuing a Forward-starting CDS <BR id=""CRLF"">18.1.2 Other forward-starting structures<BR id=""CRLF"">18.2 Valuing Credit Default Swaptions <BR id=""CRLF"">18.3 Valuing other Credit Options <BR id=""CRLF"">18.4 Alternative Valuation Approaches <BR id=""CRLF"">18.5 Valuing Bond Options<BR id=""CRLF"">IV Introduction to Credit Modeling II: Portfolio Credit Risk<BR id=""CRLF"">19 The Basics of Portfolio Credit Risk <BR id=""CRLF"">19.1 Default Correlation <BR id=""CRLF"">19.1.1 Pairwise default correlation <BR id=""CRLF"">19.1.2 Modeling default correlation <BR id=""CRLF"">19.1.3 Pairwise default correlation and \"" <BR id=""CRLF"">19.2 The Loss Distribution Function <BR id=""CRLF"">19.2.1 Conditional loss distribution function<BR id=""CRLF"">19.2.2 Unconditional loss distribution function <BR id=""CRLF"">19.2.3 Large-portfolio approximation <BR id=""CRLF"">19.3 Default Correlation and Loss Distribution<BR id=""CRLF"">19.4 Monte Carlo Simulation: Brief Overview <BR id=""CRLF"">19.4.1 How Accurate is the Simulation-Based Method?<BR id=""CRLF"">19.4.2 Evaluating the Large-Portfolio Method <BR id=""CRLF"">19.5 Conditional vs. Unconditional Loss Distributions<BR id=""CRLF"">19.6 Other Approaches to Portfolio Credit Risk Modeling<BR id=""CRLF"">20 Valuing Basket Default Swaps <BR id=""CRLF"">20.1 Basic Features of Basket Swaps <BR id=""CRLF"">20.2 Reexamining the Two-Asset FTD Basket <BR id=""CRLF"">20.3 FTD Basket with Several Reference Entities <BR id=""CRLF"">20.3.1 A simple numerical example <BR id=""CRLF"">20.3.2 A more realistic valuation exercise<BR id=""CRLF"">20.4 The Second-to-Default Basket <BR id=""CRLF"">20.5 Basket Valuation and Asset Correlation<BR id=""CRLF"">20.6 Extensions and Alternative Approaches<BR id=""CRLF"">21 Valuing Portfolio Swaps and CDOs <BR id=""CRLF"">21.1 A Simple Numerical Example <BR id=""CRLF"">21.2 Model-based Valuation Exercise <BR id=""CRLF"">21.3 The E_ects of Asset Correlation <BR id=""CRLF"">21.4 The Large-Portfolio Approximation <BR id=""CRLF"">21.5 Valuing CDOs: Some basic insights <BR id=""CRLF"">21.5.1 Special considerations for CDO valuation<BR id=""CRLF"">21.6 Concluding Remarks <BR id=""CRLF"">22 A Quick Tour of Commercial Models <BR id=""CRLF"">22.1 CreditMetrics <BR id=""CRLF"">22.2 The KMV Framework<BR id=""CRLF"">22.3 CreditRisk+<BR id=""CRLF"">22.4 Moody’s Binomial Expansion Technique <BR id=""CRLF"">22.5 Intensity-based Models<BR id=""CRLF"">22.6 Concluding Thoughts<BR id=""CRLF"">23 Modeling Counterparty Credit Risk <BR id=""CRLF"">23.1 The Single-Name CDS as a \Two-Asset Portfolio""<BR id=""CRLF"">23.2 The Basic Model<BR id=""CRLF"">23.3 A CDS with No Counterparty Credit Risk<BR id=""CRLF"">23.4 A CDS with Counterparty Credit Risk <BR id=""CRLF"">23.4.1 Analytical derivation of joint probabilities of default <BR id=""CRLF"">23.4.2 Simulation-based approach <BR id=""CRLF"">23.4.3 An Example<BR id=""CRLF"">23.5 Other Models and Approaches<BR id=""CRLF"">23.6 Counterparty Credit Risk in Multiname Structures<BR id=""CRLF"">V A Brief Overview of Documentation and Regulatory Issues <BR id=""CRLF"">24 Anatomy of a CDS Transaction <BR id=""CRLF"">24.1 Standardization of CDS Documentation<BR id=""CRLF"">24.1.1 Essential terms of a CDS transaction<BR id=""CRLF""> The reference entity <BR id=""CRLF""> Reference and deliverable obligations<BR id=""CRLF""> Settlement method<BR id=""CRLF""> Credit events <BR id=""CRLF"">24.1.2 Other important details of a CDS transaction<BR id=""CRLF"">24.2 When a Credit Event Takes Place<BR id=""CRLF"">24.2.1 Credit event noti_cation and veri_cation<BR id=""CRLF"">24.2.2 Settling the contract<BR id=""CRLF"">24.3 The Restructuring Debate <BR id=""CRLF"">24.3.1 A case in point: Conseco <BR id=""CRLF"">24.3.2 Modi_ed Restructuring<BR id=""CRLF"">24.3.3 A Bifurcated Market<BR id=""CRLF"">24.4 Valuing the Restructuring Clause <BR id=""CRLF"">24.4.1 Implications for implied survival probabilities<BR id=""CRLF"">25 A Primer on Bank Regulatory Issues <BR id=""CRLF"">25.1 The Basel II Capital Accord <BR id=""CRLF"">25.2 Basel II Risk Weights and Credit Derivatives<BR id=""CRLF"">25.3 Suggestions for Further Reading <BR id=""CRLF"">Appendix A Basic Concepts from Bond Math <BR id=""CRLF"">A.1 Zero-coupon Bonds <BR id=""CRLF"">A.2 Compounding <BR id=""CRLF"">A.3 Zero-coupon Bond Prices as Discount Factors <BR id=""CRLF"">A.4 Coupon-paying Bonds <BR id=""CRLF"">A.5 Inferring Zero-coupon Yields from the Coupon Curve <BR id=""CRLF"">A.6 Forward Rates <BR id=""CRLF"">A.7 Forward Interest Rates and Bond Prices<BR id=""CRLF"">Appendix B Basic Concepts from Statistics <BR id=""CRLF"">B.1 Probability Density Function: Discrete Case <BR id=""CRLF"">B.2 Cumulative Distribution Function <BR id=""CRLF"">B.3 Probability Density Function: Continuous Case <BR id=""CRLF"">B.4 Expected Value and Variance <BR id=""CRLF"">B.5 Bernoulli Trials and the Bernoulli Distribution <BR id=""CRLF"">B.6 The Binomial Distribution <BR id=""CRLF"">B.7 The Poisson and Exponential Distributions <BR id=""CRLF"">B.8 The Normal Distribution<BR id=""CRLF"">B.9 The Lognormal Distribution <BR id=""CRLF"">B.10 Joint Probability Distributions <BR id=""CRLF"">B.11 Independence <BR id=""CRLF"">B.12 The Bivariate Normal Distribution


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© Academic Press 2005
6th December 2004
Academic Press
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About the Authors

Antulio Bomfim

Antulio N. Bomfim Senior Managing Director and Co-Head of Monetary Policy Insights at Macroeconomic Advisers, LLC. He received his M.A. and Ph.D. in

Economics at the University of Maryland and his Mathematical Finance at the University of Oxford.

Affiliations and Expertise

Macroeconomic Advisers, LLC, Washington, DC, USA

Antulio Bomfim

Antulio N. Bomfim Senior Managing Director and Co-Head of Monetary Policy Insights at Macroeconomic Advisers, LLC. He received his M.A. and Ph.D. in

Economics at the University of Maryland and his Mathematical Finance at the University of Oxford.

Affiliations and Expertise

Macroeconomic Advisers, LLC, Washington, DC, USA


"This enjoyable book on credit derivatives will be useful to both students of finance and practitioners. Bomfim does for credit what Hull does for options, futures and other derivatives." --Kay Giesecke, Visiting Assistant Professor, School of Operations Research and Industrial Engineering, Cornell University "Antulio Bomfin's exploration of the pricing and valuation of credit derivatives is extraordinarily accessible and therefore will serve as an essential primer for those unfamiliar with credit derivative markets. At the same time, the depth of discourse in Understanding Credit Derivatives will be appreciated by experts who seek a better grounding in the fundamental principles of this complex market." -- Heidi Mandanis Schooner, Visiting Professor of Law, George Washington University Law School "Comprehensive in coverage, economical in exposition, very accessible, and a pleasure to read - this book covers the gamut of issues in modern credit modeling in a manner that will appeal to practitioners, academics and students." -- Sanjiv Das, Professor of Finance, Santa Clara University "...offers a comprehensive introduction to the credit derivatives market. Rather than presenting a highly technical exploration of the subject, the book offers intuitive, yet rigorous summaries of the major subjects. Its centerpiece focuses on pricing and valuation issues, especially discussions of different valuation tools and their application to credit models." -- Gunter Dufey, Prof. em., The University of Michigan; Prof. of Banking and Finance, Nanyang Technological University - NBS, Singapore "Understanding Credit Derivatives and Related Instruments" is a most valuable offering in this rapidly expanding area of finance. The book provides an introduction to the credit derivatives market for the uninitiated and then addresses the pricing and valuing of these instruments, as well as describing valuation tools and their use in credit models. The book also provides a most useful description of the documentation of credit derivative transactions under the ISDA forms that govern these transactions." -- Jerry Markham, Professor of Law, Florida International University "...this is an outstanding book. I can't recommend it highly enough." -

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