The Art of Credit Derivatives: Demystifying the Black Swan

Preface

Technology has no respect for tradition.

Peter Lee

 

 

Some people say that this book has been written during unusual market conditions. Securitization activity was designed to bring liquidity for the collateral in the portfolio. Investing in securitization instruments is a diversification and it reduces idiosyncratic risk. Combined with credit derivatives, securitization led to increased leverage in financial institutions. The high leverage levels affected liquidity, bringing the financial system to the brink of collapse.

Innovation plays a crucial role in society and leverage allows economic activity to be speeded up. However, all leveraged positions need to be carefully managed, as can be seen by the dramatic events that followed the summer of 2007. Standardized credit indices are the instruments to foster the securitization business model, playing a central role in the pricing discovery. Transparency in the pricing algorithms and the underlying parameters is key to the activity.

Our main objective in this book is to present the framework to manage this leverage. Many quantitative analysts and market practitioners have contributed to the development of the toolkit for credit derivatives described here. Despite their enormous contribution, many of them have faced hard times during the dramatic market correction that began in 2007. The quotes at the begining of each chapter have been selected to honour their work.

Nowadays, the metaphor of the black swan is sometimes used ...