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Handbook of the Economics of Finance by Rene M. Stulz, Milton Harris, George M. Constantinides

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Chapter 20

Credit Derivatives

John Hull and Alan White

Joseph L. Rotman School of Management University of Toronto

Abstract

This chapter explains how the main types of credit derivatives work and how they are valued. Central to the valuation of credit derivatives is an estimation of the probability that reference entities will default. The chapter discusses both the risk-neutral probabilities of default implied from credit spreads and the real-world (physical) default probabilities calculated from historical data, such as that provided by rating agencies. The academic literature attempting to explain the difference between these two probability estimates is summarized. The characteristics of credit default swaps, which are the most common type of ...

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