Credit Derivatives : Trading, Investing,and Risk Management
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 website which contains tools for credit derivatives valuation and risk management, illustrating the models used in the book and also providing a valuation toolkit.
Preface to the First Edition xvii
Preface to the Second Edition xix
Acknowledgements xxi
Disclaimer xxiii
Table of Spreadsheet Examples and Software xxvii
About the Author xxix
PART I CREDIT BACKGROUND AND CREDIT DERIVATIVES 1
1 Credit Debt and Other Traditional Credit Instruments 3
1.1 Bonds and Loans; Libor Rates and Swaps; 'REPO' and General Collateral Rates 3
1.2 Credit Debt Versus 'Risk-Free' Debt 6
1.3 Issue Documents, Seniority and the Recovery Process 6
1.4 Valuation, Yield and Spread 10
1.5 Buying Risk 10
1.6 Marking to Market, Marking to Model and Reserves 11
1.7 The 'Credit Crunch' and Correlation 12
1.8 Parties Involved in the Credit Markets and Key Terminology 13
2 Default and Recovery Data; Transition Matrices; Historical Pricing 15
2.1 Recovery: Ultimate and Market-Value-Based Recovery 15
2.2 Default Rates: Rating and Other Factors 21
2.3 Transition Matrices 21
2.4 'Measures' and Transition Matrix-Based Pricing 22
2.5 Spread Jumps and Spread Volatility Derived from Transition Matrices 26
2.6 Adjusting Transition Matrices 27
3 Asset Swaps and Asset Swap Spread; z-Spread 29
3.1 'Par-Par' Asset Swap Contracts 29
3.2 Asset Swap Spread 30
3.3 Maturity and z-Spread 30
3.4 Callable Asset Swaps; 'Perfect' Asset Swaps 32
3.5 A Bond Spread Model 33
4 Liquidity, the Credit Pyramid and Market Data 35
4.1 Bond Liquidity 35
4.2 The Credit Pyramid 35
4.3 Engineered and Survey Data 37
4.4 Spread and Rating 39
5 Traditional Counterparty Risk Management 41
5.1 Vetting 41
5.2 Collateralisation and Netting 41
5.3 Additional Counterparty Requirements for Credit Derivative Counterparties 42
5.4 Internal Capital Charge 42
6 Credit Portfolios and Portfolio Risk 43
6.1 VaR and counterpartyVaR 43
6.2 Distribution of Forward Values of a Credit Bond 43
6.3 Correlation and the Multi-Factor Normal (Gaussian) Distribution 45
6.4 Correlation and the Correlation Matrix 46
7 Introduction to Credit Derivatives 49
7.1 Products and Users 49
7.2 Market Participants and Market Growth 51
PART II CREDIT DEFAULT SWAPS AND OTHER SINGLE NAME PRODUCTS 55
8 Credit Default Swaps; Product Description and Simple Applications 57
8.1 CDS Product Definition 57
8.2 Documentation 60
8.3 Credit Triggers for Credit Derivatives 65
8.4 CDS Applications and Elementary Strategies 67
8.5 Counterparty Risk: PFE for CDS 71
8.6 CDS Trading Desk 71
8.7 CDS Contract and Convention Changes 2009 73
9 Valuation and Risk: Basic Concepts and the Default and Recovery Model 81
9.1 The Fundamental Credit Arbitrage – Repo Cost 81
9.2 Default and Recovery Model; Claim Amount 82
9.3 Deterministic Default Rate Model 87
9.4 Stochastic Default Rate Model; Hazard and Pseudo-Hazard Rates 94
9.5 Calibration to Market Data 97
9.6 CDS Data/Sources 102
9.7 Model Errors and Tests 105
9.8 CDS Risk Factors; Reserves and Model Risk 108
10 CDS Deal Examples 113
10.1 A CDS Hedged Against Another CDS 113
10.2 Introduction to Bond Hedging 124
10.3 Hedge and Credit Event Examples 126
11 CDS/Bond Basis Trading 131
11.1 Bond Versus CDS: Liquidity 131
11.2 Bond Repo Cost 132
11.3 Bond Spread Measurement – z-Spread not Asset Swap Spread 133
11.4 Bond Price Impact 133
11.5 Embedded Options in Bonds and Loans 134
11.6 Delivery Option in CDSs 135
11.7 Payoff of Par 136
11.8 Trigger Event Differences 136
11.9 Embedded Repo Option 137
11.10 Putting it All Together 138
12 Forward CDS; Back-to-Back CDS, Mark to Market and CDS Unwind 139
12.1 Forward CDS 139
12.2 Mark-to-Market and Back-to-Back CDS 140
12.3 Unwind Calculation; Off-Market Trade Valuation and Hedging 141
12.4 'Double-Trigger CDS' 142
13 Credit-Linked Notes 145
13.1 CLN Set-Up; Counterparty or Collateral Risk 145
13.2 Embedded Swaps and Options 147
13.3 Costs 148
13.4 Applications 148
13.5 CLN Pricing 149
13.6 Capital Guaranteed Note 150
14 Digital or 'Fixed Recovery' CDS 155
14.1 Product Description 155
14.2 Pricing, Hedging, Valuation and Risk Calculations 155
14.3 Trigger Event Differences 157
15 Spread Options, Callable/Puttable Bonds, Callable Asset Swaps, Callable Default Swaps 159
15.1 Product Definitions 159
15.2 Model Alternatives and a Stochastic Default Rate Model for Spread Option Pricing 162
15.3 Sensitivities and Hedging 164
16 Total Return Swaps 167
16.1 Product Definition and Examples 167
16.2 Applications 167
16.3 Hedging and Valuation 168
17 Single Name Book Management 171
17.1 Risk Aggregation 171
17.2 CreditVaR for CDSs 173
18 CDS and Simulation 175
18.1 The Poisson Model and Default Times 175
18.2 Valuation by Monte Carlo Simulation 175
18.3 Sensitivity 178
PART III PORTFOLIO PRODUCTS 181
19 Portfolio Product Types 183
19.1 Nth-to-Default Baskets 184
19.2 'Synthetic' CDOs 188
19.3 Cashflow CDOs 210
19.4 Credit Securitisations 220
19.5 Rating 222
19.6 Alternative Levered Credit Portfolio Products 222
20 The Normal Copula and Correlation 227
20.1 Default Time Correlation 227
20.2 Normal Copula 236
20.3 Correlation 244
21 Correlation in Practice 253
21.1 Tranche Correlation 253
21.2 Base Correlation 257
21.3 Correlated Recoveries 261
21.4 Correlation Regime Change and Other Modelling Approaches 262
22 Valuation and Hedging 265
22.1 Valuation Examples 265
22.2 Sensitivity Calculation and Hedging 270
22.3 Pricing More Complex Structures 282
22.4 Model Errors and Tests; Alternative Models 284
23 Alternative Copulas 289
23.1 Student's t-Distribution 289
23.2 Copulas in General 290
23.3 Archimedean Copulas: Clayton, Gumbel 291
23.4 Clayton at theta = 0 and theta = infinity 293
23.5 Model Risk 293
24 Correlation Portfolio Management 297
24.1 Static and Dynamic Hedges 297
24.2 Correlation Book Management 298
24.3 CreditVaR and CounterpartyVaR 300
PART IV DEFAULT SWAPS INCLUDING COUNTERPARTY RISK 303
25 Single Name CDS 303
25.1 Non-Correlated Counterparty 305
25.2 100% Correlation 306
25.3 Correlated Counterparty: Pricing and Hedging 308
25.4 Choice of Copula 309
25.5 Collateralised Deals and CDS Book Management 309
26 Counterparty CDSs 313
26.1 Pricing 313
26.2 Counterparty CDS (CCDS) Book Management 313
PART V SYSTEMS IMPLEMENTATION AND TESTING 317
27 Mathematical Model and Systems Validation 319
27.1 Testing Procedures 319
27.2 Implementation and Documentation 321
28 System Implementation 323
28.1 Anatomy of a CDO 323
28.2 Management 325
28.3 Valuation 329
28.4 IT Considerations 331
PART VI THE CREDIT CRISIS 335
29 Cause and Effect: Credit Derivatives and the Crisis of 2007 337
29.1 The Credit Markets Pre-Crisis 337
29.2 The Events of MID-2007 341
29.3 Issues to be Addressed 346
29.4 Market Clearing Mechanisms 350
Appendix Markit Credit and Loan Indices 355
References 363
Index 365
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