Fixed Income Relative Value Analysis: A Practitioners Guide to the Theory, Tools, and Trades

Chapter 15

Credit Default Swaps

Introduction

So far, we’ve focused on deriving relative value relations between instruments relying mainly on the no-arbitrage principle, an approach that is possible based on the maintained assumption that the cash flows that define these instruments have been free from default risk.

In Chapter 14, however, we discussed empirical relations between US Treasuries, German Bunds, and JGBs that strongly suggested the need for incorporating credit risk in our analysis, particularly for JGBs. And as the pool of plausibly default-free issuers shrinks still further, incorporating credit risk into relative value analysis and trading becomes increasingly important.

There are two general approaches for incorporating credit ...