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Credit Derivatives: Trading, Investing and Risk Management, Second Edition

Book Description

The credit derivatives industry has come under close scrutiny over the past few years, with the recent financial crisis highlighting the instability of a number of credit structures and throwing the industry into turmoil. What has been made clear by recent events is the necessity for a thorough understanding of credit derivatives by all parties involved in a transaction, especially traders, structurers, quants and investors.

Fully revised and updated to take in to account the new products, markets and risk requirements post financial crisis, Credit Derivatives: Trading, Investing and Risk Management, Second Edition, covers the subject from a real world perspective, tackling issues such as liquidity, poor data, and credit spreads, to the latest innovations in portfolio products, hedging and risk management techniques.

The book concentrates on practical issues and develops an understanding of the products through applications and detailed analysis of the risks and alternative means of trading.

It provides:

  • a description of the key products, applications, and an analysis of typical trades including basis trading, hedging, and credit structuring;

  • analysis of the industry standard 'default and recovery' and Copula models including many examples, and a description of the models' shortcomings;

  • tools and techniques for the management of a portfolio or book of credit risks including appropriate and inappropriate methods of correlation risk management;

  • a thorough analysis of counterparty risk;

  • an intuitive understanding of credit correlation in reality and in the Copula model.

The book is thoroughly updated to reflect the changes the industry has seen over the past 5 years, notably with an analysis of the lead up and causes of the credit crisis. It contains 50% new material, which includes copula valuation and hedging, portfolio optimisation, portfolio products and correlation risk management, pricing in illiquid environments, chapters on the evolution of credit management systems, the credit meltdown and new chapters on the implementation and testing of credit derivative models and systems.

The book is accompanied by a CD ROM which contains tools for credit derivatives valuation and risk management, illustrating the models used in the book and also providing a valuation toolkit.

Note: CD-ROM/DVD and other supplementary materials are not included as part of eBook file.

Table of Contents

  1. Dedication
  2. Title Page
  3. Copyright Page
  4. Preface to the First Edition
  5. Preface to the Second Edition
  6. Acknowledgements
  7. Disclaimer
    1. INSTRUCTIONS FOR THE ‘NDB PRICER’ AND THE ‘CDO PRICER’
    2. APPLICATION RESTRICTIONS
  8. Table of Spreadsheet Examples and Software
  9. About the Author
  10. Part I - Credit Background and Credit Derivatives
    1. Chapter 1 - Credit Debt and Other Traditional Credit Instruments
      1. 1.1 BONDS AND LOANS; LIBOR RATES AND SWAPS; ‘REPO’ AND GENERAL COLLATERAL RATES
      2. 1.2 CREDIT DEBT VERSUS ‘RISK-FREE’ DEBT
      3. 1.3 ISSUE DOCUMENTS, SENIORITY AND THE RECOVERY PROCESS
      4. 1.4 VALUATION, YIELD AND SPREAD
      5. 1.5 BUYING RISK
      6. 1.6 MARKING TO MARKET, MARKING TO MODEL AND RESERVES
      7. 1.7 THE ‘CREDIT CRUNCH’ AND CORRELATION
      8. 1.8 PARTIES INVOLVED IN THE CREDIT MARKETS AND KEY TERMINOLOGY
    2. Chapter 2 - Default and Recovery Data; Transition Matrices; Historical Pricing
      1. 2.1 RECOVERY: ULTIMATE AND MARKET-VALUE-BASED RECOVERY
      2. 2.2 DEFAULT RATES: RATING AND OTHER FACTORS
      3. 2.3 TRANSITION MATRICES
      4. 2.4 ‘MEASURES’ AND TRANSITION MATRIX-BASED PRICING
      5. 2.5 SPREAD JUMPS AND SPREAD VOLATILITY DERIVED FROM TRANSITION MATRICES
      6. 2.6 ADJUSTING TRANSITION MATRICES
    3. Chapter 3 - Asset Swaps and Asset Swap Spread; z-Spread
      1. 3.1 ‘PAR-PAR’ ASSET SWAP CONTRACTS
      2. 3.2 ASSET SWAP SPREAD
      3. 3.3 MATURITY AND z-SPREAD
      4. 3.4 CALLABLE ASSET SWAPS; ‘PERFECT’ ASSET SWAPS
      5. 3.5 A BOND SPREAD MODEL
    4. Chapter 4 - Liquidity, the Credit Pyramid and Market Data
      1. 4.1 BOND LIQUIDITY
      2. 4.2 THE CREDIT PYRAMID
      3. 4.3 ENGINEERED AND SURVEY DATA
      4. 4.4 SPREAD AND RATING
    5. Chapter 5 - Traditional Counterparty Risk Management
      1. 5.1 VETTING
      2. 5.2 COLLATERALISATION AND NETTING
      3. 5.3 ADDITIONAL COUNTERPARTY REQUIREMENTS FOR CREDIT DERIVATIVE COUNTERPARTIES
      4. 5.4 INTERNAL CAPITAL CHARGE
    6. Chapter 6 - Credit Portfolios and Portfolio Risk
      1. 6.1 VaR AND COUNTERPARTYVaR
      2. 6.2 DISTRIBUTION OF FORWARD VALUES OF A CREDIT BOND
      3. 6.3 CORRELATION AND THE MULTI-FACTOR NORMAL (GAUSSIAN) DISTRIBUTION
      4. 6.4 CORRELATION AND THE CORRELATION MATRIX
    7. Chapter 7 - Introduction to Credit Derivatives
      1. 7.1 PRODUCTS AND USERS
      2. 7.2 MARKET PARTICIPANTS AND MARKET GROWTH
  11. Part II - Credit Default Swaps and other Single Name Products
    1. Chapter 8 - Credit Default Swaps; Product Description and Simple Applications
      1. 8.1 CDS PRODUCT DEFINITION
      2. 8.2 DOCUMENTATION
      3. 8.3 CREDIT TRIGGERS FOR CREDIT DERIVATIVES
      4. 8.4 CDS APPLICATIONS AND ELEMENTARY STRATEGIES
      5. 8.5 COUNTERPARTY RISK: PFE FOR CDS
      6. 8.6 CDS TRADING DESK
      7. 8.7 CDS CONTRACT AND CONVENTION CHANGES 2009
    2. Chapter 9 - Valuation and Risk: Basic Concepts and the Default and Recovery Model
      1. 9.1 THE FUNDAMENTAL CREDIT ARBITRAGE - REPO COST
      2. 9.2 DEFAULT AND RECOVERY MODEL; CLAIM AMOUNT
      3. 9.3 DETERMINISTIC DEFAULT RATE MODEL
      4. 9.4 STOCHASTIC DEFAULT RATE MODEL; HAZARD AND PSEUDO-HAZARD RATES
      5. 9.5 CALIBRATION TO MARKET DATA
      6. 9.6 CDS DATA/SOURCES
      7. 9.7 MODEL ERRORS AND TESTS
      8. 9.8 CDS RISK FACTORS; RESERVES AND MODEL RISK
    3. Chapter 10 - CDS Deal Examples
      1. 10.1 A CDS HEDGED AGAINST ANOTHER CDS
      2. 10.2 INTRODUCTION TO BOND HEDGING
      3. 10.3 HEDGE AND CREDIT EVENT EXAMPLES
    4. Chapter 11 - CDS/Bond Basis Trading
      1. 11.1 BOND VERSUS CDS: LIQUIDITY
      2. 11.2 BOND REPO COST
      3. 11.3 BOND SPREAD MEASUREMENT - z-SPREAD NOT ASSET SWAP SPREAD
      4. 11.4 BOND PRICE IMPACT
      5. 11.5 EMBEDDED OPTIONS IN BONDS AND LOANS
      6. 11.6 DELIVERY OPTION IN CDSs
      7. 11.7 PAYOFF OF PAR
      8. 11.8 TRIGGER EVENT DIFFERENCES
      9. 11.9 EMBEDDED REPO OPTION
      10. 11.10 PUTTING IT ALL TOGETHER
    5. Chapter 12 - Forward CDS; Back-to-Back CDS, Mark to Market and CDS Unwind
      1. 12.1 FORWARD CDS
      2. 12.2 MARK-TO-MARKET AND BACK-TO-BACK CDS
      3. 12.3 UNWIND CALCULATION; OFF-MARKET TRADE VALUATION AND HEDGING
      4. 12.4 ‘DOUBLE-TRIGGER CDS’
    6. Chapter 13 - Credit-Linked Notes
      1. 13.1 CLN SET-UP; COUNTERPARTY OR COLLATERAL RISK
      2. 13.2 EMBEDDED SWAPS AND OPTIONS
      3. 13.3 COSTS
      4. 13.4 APPLICATIONS
      5. 13.5 CLN PRICING
      6. 13.6 CAPITAL GUARANTEED NOTE
    7. Chapter 14 - Digital or ‘Fixed Recovery’ CDS
      1. 14.1 PRODUCT DESCRIPTION
      2. 14.2 PRICING, HEDGING, VALUATION AND RISK CALCULATIONS
      3. 14.3 TRIGGER EVENT DIFFERENCES
    8. Chapter 15 - Spread Options, Callable/Puttable Bonds, Callable Asset Swaps, Callable Default Swaps
      1. 15.1 PRODUCT DEFINITIONS
      2. 15.2 MODEL ALTERNATIVES AND A STOCHASTIC DEFAULT RATE MODEL FOR SPREAD OPTION PRICING
      3. 15.3 SENSITIVITIES AND HEDGING
    9. Chapter 16 - Total Return Swaps
      1. 16.1 PRODUCT DEFINITION AND EXAMPLES
      2. 16.2 APPLICATIONS
      3. 16.3 HEDGING AND VALUATION
    10. Chapter 17 - Single Name Book Management
      1. 17.1 RISK AGGREGATION
      2. 17.2 CREDITVaR FOR CDSs
    11. Chapter 18 - CDS and Simulation
      1. 18.1 THE POISSON MODEL AND DEFAULT TIMES
      2. 18.2 VALUATION BY MONTE CARLO SIMULATION
      3. 18.3 SENSITIVITY
  12. Part III - Portfolio Products
    1. Chapter 19 - Portfolio Product Types
      1. 19.1 NTH-TO-DEFAULT BASKETS
      2. 19.2 ‘SYNTHETIC’ CDOs
      3. 19.3 CASHFLOW CDOS
      4. 19.4 CREDIT SECURITISATIONS
      5. 19.5 RATING
      6. 19.6 ALTERNATIVE LEVERED CREDIT PORTFOLIO PRODUCTS
    2. Chapter 20 - The Normal Copula and Correlation
      1. 20.1 DEFAULT TIME CORRELATION
      2. 20.2 NORMAL COPULA
      3. 20.3 CORRELATION
    3. Chapter 21 - Correlation in Practice
      1. 21.1 TRANCHE CORRELATION
      2. 21.2 BASE CORRELATION
      3. 21.3 CORRELATED RECOVERIES
      4. 21.4 CORRELATION REGIME CHANGE AND OTHER MODELLING APPROACHES
    4. Chapter 22 - Valuation and Hedging
      1. 22.1 VALUATION EXAMPLES
      2. 22.2 SENSITIVITY CALCULATION AND HEDGING
      3. 22.3 PRICING MORE COMPLEX STRUCTURES
      4. 22.4 MODEL ERRORS AND TESTS; ALTERNATIVE MODELS
    5. Chapter 23 - Alternative Copulas
      1. 23.1 STUDENT’S t-DISTRIBUTION
      2. 23.2 COPULAS IN GENERAL
      3. 23.3 ARCHIMEDEAN COPULAS: CLAYTON, GUMBEL
      4. 23.4 CLAYTON AT θ = 0 AND θ = ∞
      5. 23.5 MODEL RISK
    6. Chapter 24 - Correlation Portfolio Management
      1. 24.1 STATIC AND DYNAMIC HEDGES
      2. 24.2 CORRELATION BOOK MANAGEMENT
      3. 24.3 CREDITVaR AND COUNTERPARTYVaR
  13. Part IV - Default Swaps Including Counterparty Risk
    1. Chapter 25 - ‘Single Name’ CDS
      1. 25.1 NON-CORRELATED COUNTERPARTY
      2. 25.2 100% CORRELATION
      3. 25.3 CORRELATED COUNTERPARTY: PRICING AND HEDGING
      4. 25.4 CHOICE OF COPULA
      5. 25.5 COLLATERALISED DEALS AND CDS BOOK MANAGEMENT
    2. Chapter 26 - Counterparty CDSs
      1. 26.1 PRICING
      2. 26.2 COUNTERPARTY CDS (CCDS) BOOK MANAGEMENT
  14. Part V - Systems Implementation and Testing
    1. Chapter 27 - Mathematical Model and Systems Validation
      1. 27.1 TESTING PROCEDURES
      2. 27.2 IMPLEMENTATION AND DOCUMENTATION
    2. Chapter 28 - System Implementation
      1. 28.1 ANATOMY OF A CDO
      2. 28.2 MANAGEMENT
      3. 28.3 VALUATION
      4. 28.4 IT CONSIDERATIONS
  15. Part VI - The Credit Crisis
    1. Chapter 29 - Cause and Effect: Credit Derivatives and the Crisis of 2007
      1. 29.1 THE CREDIT MARKETS PRE-CRISIS
      2. 29.2 THE EVENTS OF MID-2007
      3. 29.3 ISSUES TO BE ADDRESSED
      4. 29.4 MARKET CLEARING MECHANISMS
  16. Appendix - Markit Credit and Loan Indices
  17. References
  18. Index