Credit derivatives and structured credit

✍ Scribed by Richard Bruyere, Regis Copinot, Loic Fery, Christophe Jaeck, Thomas Spitz, Gabrielle Smart, Rama Cont

• Publisher: Wiley
• Year: 2006
• Tongue: English
• Leaves: 295
• Series: The Wiley Finance Series
• Category: Library

✦ Synopsis

Over the past decade, credit derivatives have emerged as the key financial innovation in global capital markets. At end 2004, the market size hit $6.4 billion (in notional amounts) from virtually nothing in 1995. This rise has been spurred by the imperative for banks to better manage their risks, not least credit risks, and the appetite shown by institutional investors and hedge funds for innovative, high yielding structured investment products. As a result, growth in collateralized debt obligations and other second-generation products, such as credit indices, is currently phenomenal. It is enabled by the standardization and increased liquidity in credit default swaps – the building block of the credit derivatives market.

Written by market practitioners and specialists, this book covers the fundamentals of the credit derivatives and structured credit market, including in-depth product descriptions, analysis of real transactions, market overview, pricing models, banks business models. It is recommended reading for students in business schools and financial courses, academics, and professionals working in investment and asset management, banking, corporate treasury and the capital markets.

Highlights include:

• Written by market practitioners and specialists with first-hand experience in the credit derivatives and structured credit market
• A clearly-written, pedagogical book with numerous illustrations
• Detailed review of real-case transactions
• A comprehensive historical perspective on market developments including up-to-date analysis of the latest trends

✦ Table of Contents

Credit Derivatives and Structured Credit......Page 3
Contents......Page 7
Foreword......Page 11
Introduction......Page 13
1.1 Credit Risk......Page 17
1.1.1 Definition and Typology of Credit Risk......Page 19
1.1.2 Characteristics of Credit Risk......Page 20
1.1.3 The Importance of Credit Risk in Capital Markets......Page 24
1.2.1 Bank Capital Adequacy Standards (Basel I)......Page 27
1.2.2 Credit Risk Analyzed by Rating Agencies......Page 30
1.2.3 Credit Risk Measured in the Financial Markets: Credit Spread......Page 36
1.3 Traditional Methods of Credit Risk Management and the Emergence of Credit Derivatives......Page 40
1.3.1 Traditional Methods for Managing Credit Risk (Issuer Risk)......Page 41
1.3.2 Counterparty Risk Management in Derivatives Markets......Page 43
1.3.3 Emergence and Advantages of Credit Derivatives......Page 45
2.1 Credit Default Swaps......Page 51
2.1.1 Description of Credit Default Swaps......Page 52
2.1.2 Comparison Between the CDS Market and the Cash Market: Basis......Page 61
2.1.3 Main Variations on CDSs......Page 65
2.2.1 Credit Spread Derivatives......Page 71
2.2.2 Synthetic Replication Products......Page 77
2.3.1 Applications for Institutional Investors and Other Capital Market players......Page 82
2.3.2 Credit Derivative Applications in Bank Management......Page 86
2.3.3 Credit Derivative Applications for Corporates......Page 90
3.1 Basket Credit Default Swaps......Page 97
3.1.1 First-to-Default Credit Swaps......Page 98
3.1.2 Concrete Example......Page 103
3.1.3 Extension of the First-to-Default Principle: i to j-to-Default Products......Page 105
3.2.1 Capital-Guaranteed/Protected Products......Page 106
3.2.2 Other Hybrid Products......Page 108
3.2.3 Concrete Example of a Transaction......Page 109
3.3.1 Introduction to Credit Indices......Page 110
3.3.2 Credit Index Mechanism, Pricing and Construction......Page 112
3.3.3 iTraxx Indices: a True Innovation to Benefit Investors......Page 117
4 Collateralized Debt Obligations......Page 121
4.1.1 Origin of Arbitrage CBOs/CLOs......Page 123
4.1.2 Description of a CDO Structure......Page 125
4.1.3 Overview of the CBO/CLO Market and Recent Developments......Page 129
4.2.1 Securitization of Bank Loans......Page 130
4.2.2 The Impact of Credit Derivatives: Synthetic CLOs......Page 131
4.2.3 Balance Sheet-Driven CDOs and Regulatory Arbitrage......Page 135
4.3.1 The First Arbitrage-Driven Synthetic CDOs......Page 140
4.3.2 Actively Managed Arbitrage-Driven Synthetic CDOs......Page 144
4.3.3 On-Demand CDOs (Correlation Products)......Page 149
5 The Credit Derivatives and Structured Credit Products Market......Page 165
5.1 Overview of the Market......Page 166
5.1.1 Main Stages in the Development of the Credit Derivatives Market......Page 167
5.1.2 Size, Growth and Structure of the Credit Derivatives Market......Page 168
5.1.3 Size, Growth and Structure of the CDO Market......Page 175
5.2 Main Players......Page 176
5.2.1 Banks......Page 177
5.2.2 Insurance, Reinsurance Companies and Financial Guarantors......Page 179
5.2.3 Hedge Funds and Traditional Asset Managers......Page 181
5.2.4 Corporates......Page 183
5.3.1 Position of the Investment Banks in the Credit Derivatives Market......Page 184
5.3.2 Position of the Investment Banks in the CDO Market......Page 186
5.3.3 Functions and Organization of Investment Banks......Page 188
6 Pricing Models for Credit Derivatives......Page 191
6.1.1 The Black–Scholes Option Pricing Model......Page 192
6.1.2 Merton’s Structural Model of Default Risk (1976)......Page 194
6.1.3 Limitations and Extensions of the Merton Model (1976)......Page 196
6.1.4 Pricing and Hedging Credit Derivatives in Structural Models......Page 199
6.2.1 Hazard Rate and Credit Spreads......Page 200
6.2.2 Pricing and Hedging of Credit Derivatives in Reduced-Form Models......Page 203
6.2.3 Accounting for the Volatility of Credit Spreads......Page 204
6.3 Pricing Models for Multi-Name Credit Derivatives......Page 205
6.3.1 Correlation, Dependence and Copulas......Page 206
6.3.2 The Gaussian Copula Model......Page 207
6.3.4 Dependent Defaults in Reduced-Form Models......Page 211
6.4.1 Comparing Structural and Reduced-Form Modeling Approaches......Page 212
6.4.2 Complex Models, Sparse Data Sets......Page 213
6.4.3 Stand-alone Pricing Versus Marginal Pricing......Page 214
7 The Impact of the Development in Credit Derivatives......Page 215
7.1.1 Far-Reaching Changes in the Capital Markets......Page 216
7.1.2 An Economic Approach to Credit Risk Management......Page 220
7.1.3 Overview of the Banks of the Twenty-First Century: the Effect of Credit Derivatives on Banks’ Strategy, Organization and Culture......Page 233
7.2.1 Credit Derivatives and the New Basel II Regulations......Page 239
7.2.2 Credit Derivatives and the Instability of the Financial System......Page 250
7.2.3 A More Rounded Picture......Page 253
7.3 Credit Derivatives: A Financial Revolution?......Page 257
7.3.1 Introduction to Particle Finance Theory......Page 258
7.3.2 Implications of ‘Particle Finance Theory’ for the Capital Markets......Page 259
7.3.3 An Innovation that Heralds Others......Page 263
Conclusion......Page 267
References......Page 271
Further Reading......Page 275
Index......Page 279