Credit Derivatives An Introduction To The Products

Credit Derivatives: An introduction to the products,
applications, participants and pricing.
Michael Duncan (31384161)

mike_duncan@blueyonder.co.uk
Supervising Professor: Rae Weston

MGSM 952 Research Project
Macquarie Graduate School of Management
MBA Programme
November 2004
London
Credit Derivatives: An introduction to the products, applications, participants and pricing.
Table of Contents
Executive Summary ........................................................................................................................ 3
Introducing Credit Risk ................................................................................................................... 4
What is Credit Risk? ................................................................................................................... 4
Major Risk Categories ................................................................................................................ 5
Market vs. Credit Risk ................................................................................................................ 6
Sources of Credit Risk Exposure ................................................................................................. 7
Credit Ratings & Credit Events ................................................................................................... 7
Credit Spreads .......................................................................................................................... 10
Economical Rationale for Managing Credit Risk ....................................................................... 12
Credit Derivative Products ............................................................................................................ 14
Credit Derivatives Defined ........................................................................................................ 14
Classification of Credit Derivatives ........................................................................................... 14
Credit Event Instruments ........................................................................................................... 14
Credit Spread Instruments ......................................................................................................... 21
Total Return Instruments ........................................................................................................... 22
Total Return Instruments ........................................................................................................... 23
Credit Derivative Applications ...................................................................................................... 25
Risk Reduction ......................................................................................................................... 25
Credit Line Management ........................................................................................................... 26
Capital Management ................................................................................................................. 27
Balance sheet Management ....................................................................................................... 28
Enhancing Yields ...................................................................................................................... 28
Market Access .......................................................................................................................... 29
Market Making ......................................................................................................................... 31
The Credit Derivative Market ........................................................................................................ 32
Market Size .............................................................................................................................. 32
Participants ............................................................................................................................... 33
Products .................................................................................................................................... 35
Reference Assets ....................................................................................................................... 36
Contract Size & Maturity .......................................................................................................... 37
Credit Default Swap Spreads ..................................................................................................... 37
Relationship with other Credit Markets ..................................................................................... 37
Regulatory Treatment of Credit Derivatives .............................................................................. 38
Credit Default Swap Valuation ...................................................................................................... 39
Key Pricing Variables ............................................................................................................... 39
Default Probabilities and Recovery Rates .................................................................................. 40
Intuition behind CDS Pricing .................................................................................................... 43
Back of Envelope Valuation .................................................................................................. 44
Replication Approach to Valuation ........................................................................................... 45
Model Approach to Valuation ................................................................................................... 47
Bibliography ................................................................................................................................. 52
Books ....................................................................................................................................... 52
Articles and Reports .................................................................................................................. 52
Electronic Reference ................................................................................................................. 54
This document is copyright 2004. This document may not be copied, reproduced, exhibited, sold, rented, lent by anyone, by any
means whatsoever, without express written permission of the author.
MGSM 952, Research Project, November 2004, London Page 2

Executive Summary
Credit derivatives and structured credit instruments are relatively new compared to derivatives related to that
of market risk only and have won through a major revolution in the past few years. Indeed credit derivatives
are still subject to continual innovation as the credit derivative market continues to develop, growing both in
size (nothing to over US $ 5 trillion in less than 10 years) and in complexity.
The interest in this developing market lies not only in the large margins that banks can raise with complex,
esoteric and difficult-to-price products but more importantly in the fact that the emergence of this market has
truly completed the financial markets; by segregating credit risk completely from market risk. Creating
both arbitrage opportunities on previously poorly priced credit risk and allowing corporate and financial
intermediaries to mange their credit risk exposure.
Despite the interest and potential for the market, credit derivatives as a product class are still generally
misunderstood and have gained a mystic as a result. This mystic has quite possibly been reinforced by much
of the literature on the subject, tending to lie at one of two extremes:
Highly quantitative - this as a consequence can be very intimidating to those without a PhD.
Highly descriptive taking about but not actually showing how to value credit derivatives.
This report provides a middle ground; a general overview of the credit derivatives market is covered in an
easily comprehensible manner. Mathematical formulae are used where necessary; however examples are
provided and are designed to be readily replicated by the reader.
Aspects of the credit derivatives market that are covered in this report include:
Introducing Credit Risk - the concept of credit risk and its implications to participants within the
financial markets.
Credit Derivative Products - what they are, how they work and how they are distinguished from
one another.
Credit Derivative Applications - applications of credit derivatives products.
The Credit Derivative Market - addressing the size, growth, products used, participants,
motivations and its relationship with other credit markets (i.e. cash debt market)
Credit Default Swap Valuation - describing the intuition behind the valuation of credit default
swaps and critiquing some of the more common methodologies and techniques that can be used.
Moving away from the theory, practical examples of deriving default probabilities and actual
valuation of a credit default swap are provided.

Introducing Credit Risk1

The following section provides an overview of the basic risks that arise when dealing with financial market
instruments and contracts. Concentration is focused toward that of credit risk and how this particular type of
risk category fits into the spectrum of financial risk. However credit risk cannot be readily understood
without some idea of the other risk categories (especially market risk). The aim being to introduce the reader
to the world of credit risk and the rationale for managing this risk both effectively and efficiently.
What is Credit Risk?

Credit risk can generically be described as the risk that a loss will be experienced as result of the
counterparty to a financial contract (whether it is a security, loan or derivative) defaulting on their
contractual obligations. This description although correct, does not necessarily convey the full flavour of
credit risk, nor the aspects of its subtypes.
To provide a more comprehensive picture of what credit risk is, three principal credit risk subtypes;
counterparty risk, default risk and credit rating migration are discussed below.
Counterparty Risk
For the purchaser of a derivative contract, the primary risk is that of counterparty exposure. The purchaser
loses money if their counterparty (the seller of the derivative contract) does not honour the contract
obligations.
Counterparty risk/exposure can be calculated from the mark to market value of a derivative contract (Basle
rules require a further add-on component to this for banks). As a consequence of this mark-to-market
valuation, the risk a purchaser has to a counterparty will fluctuate on a daily basis according to market
movements. It follows that as a contract becomes increasingly in the money (has intrinsic value) for the
purchaser, counterparty risk increases. Similarly as the value of the contract deteriorates, the counterparty
risk decreases. This is known as the current exposure. In addition to this there is the potential future
exposure, which is a measure on how the current exposure may develop in the future with some degree of
statistical confidence.
Counterparty risk is only applicable when the contract the purchaser holds is in the money, when it is out of
the money the counterparty risk for the purchaser is zero (however the seller of the contract will now have
counterparty risk arising from the purchaser). Do note that in longer-term contracts (i.e. OTC derivatives
with lengthy maturities still to run, such as swaps) even with the current exposure being zero; the potential
future exposure will result in some level of counterparty risk being derived for the contract.
Credit Default Risk

Credit default risk arises when an issuer of a debt obligation (i.e. a bond) cannot honour their contractual
commitments as a result of; bankruptcy, insolvency, or repudiation and subsequently default on any
payments that it owes.
In instances of an issuer defaulting on an obligation, the investor loses money by way of the fact that
payments due to them (principal and interest) by the issuer are no longer made. Recovery of money owed via
litigation can take years and will not necessarily result in all or any of the amount owed being recovered.
Although credit default risk and counterparty risk sound one and the same, they are not. Consider the case
where an investor holding Telstra bonds seeks to protect themselves from a potential default; it is possible to
hedge potential default risk on Telstra by purchasing a credit derivative; however in doing so counterparty
risk with the seller of the credit derivative is created.
1
Giesecke, k., Credit Derivatives and Structured Credit Products, Class Lecture Notes, Cornell University, April 2002.

Credit Rating Migration

A further credit risk subtype that is particularly import is that of credit rating migration. This is essentially
the risk that a party will suffer adverse affects from a credit rating movement. This can include the company
concerned and/or an investor with a debt or equity position in the company (long or short).
Credit ratings are essentially a guide to the credit worthiness of a company, by an independent rating agency
(such as Moodys, Standard & Poors or Fitch). The higher a companies credit rating, the greater the desire
and amounts that banks are willing to lend and the cheaper the rate of interest on the loans. Similarly banks
are prepared to offer bigger credit lines (size of loans/derivatives exposure that they are prepared enter into
with a specific company) and cheaper prices on derivative contracts (as the credit risk is reduced) the better a
companies credit rating is.
Aside from a companys perspective, ratings migration will have an adverse affect on holders of a
companys loans or debt securities (or derivative contracts on these). As a company's rating deteriorates the
relative risk of a company increases, which is subsequently reflected by a widening of credit spreads (more
about these later). This translates into a higher risk premium (i.e. higher yields) required for an investor to
purchase the companies debt or equity and the consequence is that debt and equity issued by the particular
company decrease in value. Similarly tighter credit spreads resulting from a companys rating improving,
translate to increases in value for debt and equity issues by the company.
Major Risk Categories

Market Risk
The risk derived from changes in market prices or rates. Market risk exposures result when positions are
taken in the following asset classes; equity, interest rates, currency and commodities. The use of options on
these asset classes also results in an additional market risk element, that of volatility. Volatility is the relative
rate at which an assets price increases and decreases, the higher the rate of the price movement the greater
the volatility (or probability of a change in price).
Operational Risk
This is the risk of loss due to a possibility of mistake or breakdown in the management of risk exposures.
Types of loss from operational issues in the past include:
Mispricing of instruments in an age of increasing complexity of financial instruments there is no
such thing as a small pricing error. Incorrect assumptions about pricing model inputs or indeed the
actual pricing models themselves can result in huge losses. Natwest Markets are infamously known
for their losses from their swaptions book as a result of a trader using a flat volatility surface (even
worse their systems were not able to capture this).
Not understanding the risk involved organisations can quickly disappear due to the actions (or
inactions) of a select few. Even today banks become involved with markets and products that they
have no real understanding of and as a consequence cannot realistically assess any of the risks that
result.
Fraud (i.e. the rogue trader) illegal activity by an individual can result in serve losses or even
bankruptcy for a bank affected. Nick Lesson brought down Barings Bank as a result of successfully
hiding his substantial losses made from illegal trades on Singaporean and Tokyo Futures exchanges.
Systems failure this is where internal systems (technical and management) breakdown to the
extent that mispricing, fraud and mismanagement of exposures is possible in an organisation.
Legal exposure the possibility that a derivative contract or structure may be deemed illegal or
unsuitable for sale to specific clients/counterparties. As a consequence of bankruptcy by Enron and
WorldCom (just 2 of many examples) various investment banks have been indicted in the US in
relation to the creation of special purpose vehicles (SPVs) designed to distort the earnings and true
financial status of these companies.
Compliance the risk arising from violations of laws or rules and regulations. This results from
uncertainties regarding some legal issues, appropriate regulatory capital and reporting treatment.

Liquidity Risk
Is the inability to adjust a position (long or short) without significant adverse price movement. Effects of
increasing liquidity risk are:
Bid/offer spreads widening dramatically in a short time period.
Access to credit deteriorating with the result being that not only is funding (i.e. borrowing) harder to
obtain, but it is also more expensive (reflecting higher risk premiums that are demanded by lenders).
This risk is not as important for parties taking positions as hedges as they simply maintain the position until
expiry.
Systemic Risk
This can be described as a market wide liquidity breakdown or contagion style correlated defaults. Some
relatively recent examples are the Russian and Asian crises in the late 1990s and the downfall of the
telecommunications industry in the early 2000s.
Market vs. Credit Risk
Basically, credit risk is a part of market risk. However there exist illiquid contracts for which market prices
are not readily available, for example loans. Other factors, which distinguish between these two types of risk,
are:
Market vs. Credit Risk
Market Risk Credit Risk
Time horizon short (days) long (years)
Hedging standardised customised
Information market related asymmetrical
Data abundant sparse
Time horizon Market risk is short term in nature, with exposures generally held for only short periods of
time (often intra day). Credit risk exposure conversely tends to be in periods of years rather than days; as the
instruments are generally of a longer-term nature (e.g. bonds tend to be issued with tenors greater than 3
years).
Hedging Market risk exposures are readily hedged using standardised instruments such as: swaps, FRAs,
forwards, options, swaptions, futures and the physical underlying. All these instruments whether OTC or
exchange traded, are standardised to a certain degree (the only term to agree on is the size of the notional).
Credit risk is altogether a different matter, with contract details considerably more customised and
individualised (though the ISDA master agreements are improving this) but also the number of instruments
and variability in tenor 2 of instruments available, is significantly less than for market risk.
Information For market risk exposures, information is not only easy to obtain, but it could be argued as
excessive. A view on anything from oil to interest rates can be obtained from economists, analysts,
independent think tanks, industry associations and of course your friendly taxi driver 3 (to name just a small
list of possible sources). Whereas for credit risk exposures, information is asymmetrical, with one party of a
transaction often knowing more than the other and third parties frequently precluded entirely. Typically it is
the borrower/issuer4 that knows more about their debt servicing ability and general credit worthiness than the
lender/buyer, however, it can be possible for the reverse to be true.
Data Much as with information, data for market risk exposures is abundant in supply and can be readily
obtained from sources such as Bloomberg, Reuters and Bridge or your local financial newspaper. The
flipside for credit risk is that although data available on exposures is increasingly expanding, it still can be
sparse and infrequent for all but the top names.
2
Liquidity for credit default swaps is concentrated in the 5-year tenor and decreases significantly the further away from this point of the curve.
3
Taxi drivers globally, are an excellent source of debate on current political and economic issues.
4
Company financial statements increasingly seem to more a wok of fiction that fact these days.

Sources of Credit Risk Exposure

Credit risk exposures can originate from various types of financial transactions, the most significant being:
Exposure to the credit risk of an underlying counterparty. This can be through the purchase of a
corporate or sovereign bond, making a loan (corporate or retail) to a borrower or by guaranteeing the
debt of a company. This type of action is a conscious decision to take on credit risk exposure.
Exposure to the credit risk of an Over-the-Counter (OTC5) derivative counterparty. Entering
into any form of OTC derivative contract; such as swaps, options, forwards and even a combination
of these instruments, results in a risk that the counterparty to the derivative contract will default on
their obligations. With an OTC derivative instrument, the primary motive of the purchaser is to
either hedge or gain exposure to market risk (whether interest rate, currency or equity), a side effect
being the creation of a credit risk exposure.
Combinations of both; such as asset swap packages. An asset swap is generally a fixed rate
(fixed coupon) bond that is converted into a floating coupon by way of a fixed-for-floating interest
rate swap (i.e. corporate bond + IRS swap). Subsequently the purchaser of such a package picks up
credit risk exposure from the bond issuer and also from the counterparty to the swap.
Credit Ratings & Credit Events
Credit Ratings
A credit rating performed by an independent (private6) rating agency such as Moodys or Standard and
Poors (S&P) essentially provides a description of the credit worthiness of issuers bonds. In doing so a credit
rating addresses some key questions an investor will have:
How financially sound is the company that I want to invest in?
Does this company have sufficient income and cashflow to cover any liabilities?
Credit ratings for the two rating agencies range from that of AAA/Aaa (the best) to that of CCC/Caa (the
worst for a not defaulted company) 7. Ratings BBB/Baa and above are classified as investment grade
(translation, little likelihood of default) and ratings BB/Ba and below are classified as non-investment grade.
Companys bond issues with a noninvestment grade credit rating are often referred to as junk or high-
yield due to the fact that to attract investors they have to offer higher coupons relative to that of investment
grade issues. As a consequence these companies bonds are much riskier than investment grade issues and
have a higher probability of defaulting.
In addition to the two ratings classified above, there is non-rated (NR) and default (D) classifications. A non-
rated rating simply means that a company has not been rated by a rating agency. This does not imply that a
company is so bad that it wont get even a bad rating (though it can), but more often than not means that a
company is not sufficiently active in the capital markets or is too small to justify the expense of paying a
rating agency to assess them. A company with a default classification is as the name describes, in default (i.e.
not repaying their debt).
The table below shows the primary credit rating scales for S&P8 and Moodys9.
Credit Rating Scales
Classification S&P Moody's
AAA Aaa
investment AA Aa
grade A A
BBB Baa
BB Ba
non investment
B B
grade
CCC Caa
not rated NR NR
default D D
5
Exchange traded derivatives do result in credit risk exposure, however it is to a clearinghouse for which the risk of default is negligible..
6
S&P and Moodys are the two largest and most recognised but there are a number of others, Fitch especially is making inroads.
7
Actually these are simple ratings, more detailed ratings include a +/- on the rating (i.e. A+ or A-) to provide additional granularity.
8
www.standardandpoors.com
9
www.moodys.com

Additionally the rating agencies also provide a differentiation between that of long and short term credit
quality of a company by offering long and short term ratings.
Note that a credit rating should not be taken as dogma, rating agencies do get it wrong and a credit rating
does not excuse the sensible investor from undertaking their own research. Parmalat and Enron are just two
recent examples of companies that had investment grade credit ratings, that are now bankrupt or in the
process of restructuring.
Taking the credit rating concept a stage further, the table below 10 shows the historical relationship between a
companys credit rating at the start of the year and at year-end. This can be thought of as a credit rating
migration or transition table.
Average One-Year Transition Rates (1981-2003)

Rating at year-end (%)
Rating at start of
AAA AA A BBB BB B CCC D NR
year
AAA 88.07 6.81 0.6 0.14 0.06 0 0 0 4.33
AA 0.59 87.37 7.5 0.57 0.07 0.1 0.02 0.01 3.77
A 0.05 2.01 87.42 5.54 0.43 0.16 0.03 0.05 4.31
BBB 0.03 0.19 3.91 84.46 4.56 0.84 0.22 0.37 5.41
BB 0.03 0.07 0.37 5.09 76.32 7.53 1.02 1.36 8.21
B 0 0.07 0.24 0.31 4.88 73.88 4.42 6.08 10.12
CCC 0.08 0 0.25 0.51 1.36 9.32 46.27 30.85 11.36
source: S&P EU 2003 Annual Default Study and Rating Transitions
What this table demonstrates is the probability of a companys credit rating moving higher or lower in a one-
year period. As an example for companies with an initial credit rating of BB, by year-end the following
credit rating migrations will have occurred:
0.03% will be upgraded to AAA
0.07% will be upgraded to AA
0.37% will be upgraded to A
5.09% will be upgraded to BBB
76.32% will have their rating unchanged at BB
7.53% will be downgraded to B
1.02% will be down graded to CCC
1.36% will be in default
8.21% will no longer be rated
Likewise company default data is also available with the table below, Cumulative Average Default Rates 11
showing the cumulative probability of default per rating category over time.
Cumulative Average Default Rates (1981-2003) %

Rating Year 1 Year 2 Year 3 Year 4 Year 5
AAA 0 0 0.03 0.06 0.1
AA 0.01 0.04 0.1 0.19 0.31
A 0.05 0.15 0.28 0.45 0.65
BBB 0.37 1.01 1.67 2.53 3.41
BB 1.36 4.02 7.12 9.92 12.38
B 6.08 13.31 19.2 23.66 26.82
CCC 30.85 39.76 45.47 49.53 53
source: S&P EU 2003 Annual Default Study and Rating Transitions
The table provides evidence that there is a strong relationship between a companys credit rating and the
probability of default. That is, the higher a companys credit rating, the lower the cumulative average default
rates (and of course vice versa).
10
S&P, EU 2003 Annual Default Study & Rating Transitions; Feb 13, 2004.
11

A secondary relationship that is shown is that of the time horizon. The greater the time horizon of a
company's obligations, the higher the probability of the company defaulting on those obligations regardless
of a companys credit rating.
Credit Events
A credit event can be thought of as the credit quality change of a firm; generally it is either that of a default
or credit rating migration (e.g. a credit rating gets lowered from AA to A).
The 1999 International Swap and Derivatives Association (ISDA) Credit Events Definitions 12
documentation, defined six possible trigger events that can be applied to credit derivative contracts:
Restructuring- an event as a result of which an agreement between the parties to a reference
obligation, as agreed by the reference asset and the holders of the relevant obligation, have become
less favourable to the holders that they would otherwise have been due to the terms of the reference
obligation being changed. Examples of changes can include; a reduction in the principal amount or
interest payable under the obligation, a postponement of payment, a change in ranking in priority of
payment or any other composition of payment.
Obligation Default obligations of a least a specified minimum amount have become capable of
being declared due and payable because of a non-payment default (i.e. a default other than a failure
to pay) by the reference asset. Bonds and loans generally contain various covenants, the violation of
which can give the lender the right to accelerate (i.e. demand repayment immediately). Notably these
violations can be technical nature (such as failing to send a report on time) as well as reflecting
deterioration in credit quality (taking on additional debt or failing to meet minimum financial ratios).
Obligation Acceleration obligations of a least a specified minimum amount have been declared
due and payable because of a non-payment default (i.e. a default other than a failure to pay) by the
reference asset. To trigger a credit event, the non-payment default must lead to the reference
obligation actually being accelerated.
Failure to Pay - a failure of the reference asset to make when due, any payments of a specified
minimum amount under one or more obligations after any Grace Period.
Repudiation/Moratorium - where the reference asset (a governmental authority as this trigger
event is only applicable to sovereigns) disaffirms, disclaims or otherwise challenges the validity of
the relevant obligations thus resulting in a Failure to Pay.
Bankruptcy- a reference assets inability to pay debts. Whether the insolvent debtor petitions for
such action or the debtor's creditors make the petition, the objective is the same: an equitable
distribution of assets to eliminate as much of the outstanding debt as possible.
Unfortunately these definitions (even after the 2003 update) are broader than those used by the major rating
agencies. As a consequence some commentators13 have estimated that the probability of a credit event under
the ISDA definitions is about 30% higher than observed historically by the agencies. Moodys 14 take a
particular dislike to the ISDA definition of bankruptcy as being excessively wide in scope. Arguing that the
act of a reference asset even contemplating the merits of bankruptcy (e.g. hiring advisors to discuss options)
if publicly reported could trigger a credit event payment, even if the reference asset does not ultimately enter
bankruptcy.
Thus a key point that should be made abundantly clear in dealing with credit derivative instruments is to
know what exactly constitutes a credit event (under which a default payment will be made), within the
parameters of the contract.
12
ISDA., ISDA Credit Event Definitions, 1999 and 2003.
13
Ernst & Young., Credit Derivatives; Financial Services, Ernst& Young LLP, London, 2003.
14
Tolk, S., Understanding the Risks In Credit Default Swaps; Structured Finance Special Report, Moodys Investor Services Inc, New York, 2001.

Credit Spreads
A credit spread is the difference in yield between that of a defaultable and a risk-free (non-defaultable)
security. The spread is the excess yield, which compensates an investor for incurring the credit risk
associated with that of a defaultable security.
Credit Spreads
Maturity Benchmark Corporate Credit
Yields Yields Spreads
(years) (%) (%) (%)
1 2.53 3.38 0.85
2 2.93 4.12 1.20
3 3.25 4.81 1.55
4 3.53 5.41 1.88
5 3.77 5.99 2.22
There are two general formats of credit spreads:
The credit spread relative to the risk-free benchmark, known as the absolute credit spread (i.e.
corporate vs. risk free security).
The credit spread between two credit sensitive securities, known as the relative credit spread (i.e.
corporate vs. corporate security).
Defaultable securities are generally corporate or emerging market sovereign issues, whilst risk-free securities
in the financial literature largely refer solely to US Treasuries, the risk free benchmark also includes
Sovereign issues from the G11 countries (such as Gilts, Bunds, JGBs and Australian Commonwealth
securities). However Libor15 based benchmarking is increasingly becoming standard.
The credit spread itself is calculated by subtracting the yield of the defaultable security from that of the risk-
free security. The mathematics of the bond price/yield relationship with that of credit spreads is presented
below.
There are two types of bonds: risk-free and defaultable
T
B*t is the price at time t of a risk-free zero coupon bond paying 1 at maturity (or T)
The bond yield y * (T ) satisfies the equation B *Tt e y (T )T
*
(1)
BtT is the price at time t of a defaultable zero coupon bond, paying 1 at maturity (or T).
The bond yield y(T ) satisfies the equation BtT e y (T )T (2)
The credit spread S (T ) is then
1 BtT
S (T ) y(T ) y (T ) ln T *
(3)
T B*t
The term structure of credit spreads is the schedule of S (T ) against maturity (T).
The Term Structure of Credit Spreads

2.50
Credit Spread (%)
2.00
1.50
1.00
0.50
0.00
0 1 2 3 4 5 6
Time (years)
15
London Interbank Offered Rate.

The workings of the formulae discussed, can be best demonstrated by providing a tangible example from the
credit spreads table.
Taking y* (3) 5.50% and y(3) 6.20% as the respective yields for the risk-free and the defaultable zero
coupon bonds maturing 3 years from now, from the credit spreads table above. It is a quick calculation to
determine that the credit spread is S (3) y (3) y* (3) 6.20% 5.50% 0.70% using equation (3).
We can also derive the 3 year credit spread of the corporate bond over the risk-free bond by using the
T
respective bond prices of B*t e.0553 0.847894 and BtT e.0623 0.830274 . Taking the formula
1 0.830274
from equations (1) and (2) for the bond prices, a quick calculation of ln results in an answer
3 0.847894
of 0.70%.
Generally the credit spread is often solely attributed to that of default risk, with the respective widening and
tightening of spreads explaining the financial markets current sentiment regarding an issuers likelihood of
default. Thus a widening (decrease in bond prices) in spreads can be interpreted as the market view that an
issuer has a increased probability of default on any securities outstanding and a tightening (increase in bond
prices) in spreads can be interpreted as the market view that an issuer has a reduced probability of default on
any securities outstanding.
Intuitively attributing credit spreads to that of relative default probability does make sense. However even a
brief observation of the financial markets in action, will show that spreads experience considerably more
volatility than can be rationalised by this logic. Indeed spreads for some issuers can fluctuate by more than
20 basis points (0.02%) in a day (e.g. from a cut or increase in base rates), without any obvious change in the
respective issuers financial circumstances, such as a rating change or deterioration in profitability. This
indicates that other factors are at play in driving the credit spreads for an issuer other than the default
probability. These additional factors include; tax, recovery, liquidity, interest rates and other market factors
(such as supply and demand for an issuers bonds). Some academics 16 have produced research, which show
that for AAA rated firms only 5% of the credit spread can be directly attributed to that of default probability
(for BBB firms this increases to 22%) with the balance of spreads derived from the additional factors
mentioned above.
16
Delianeis, G. and Geske, R., The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity and Market Factors,
University of California, Los Angeles, 2001.

Economical Rationale for Managing Credit Risk

The Modigliani-Miller 17 theorem, states that in the absence of taxes, bankruptcy costs, asymmetric
information and perfect capital markets, a firms value is unaffected by how it chooses to finance itself,
whether by debt or equity, nor by what its dividend policy is. Going further, the theorem holds that addition
or subtraction of financial risk will similarly have no bearing on a firms value.
The reality however is somewhat different, capital markets are far from perfect and as a matter of fact, none
of the theorems required conditions are actually met. Moreover a firms capital structure (the combination of
its debt and equity capital) is very closely monitored by market participants and will ultimately affect its
valuation. Similarly excessive leverage or risk taking by a firm is punished by the markets placing a discount
on both debt and equity issues, as high-risk strategy. Although the strategy can often result in higher rewards
(i.e. profitability) in the short term, it can ultimately result in higher losses (i.e. a greater probability of not
being able to service debt and higher probability of bankruptcy) in the long term.
Ultimately the economic rationale for managing credit risk within a bank is the impact it can have on the
bottom line. Successful management of credit risk enables a bank to not only avoid costly and embarrassing
losses when counterparties default, but also enables profits to be enhanced with the use of leverage and
assertive balance sheet management. Non-financial companies can also benefit from management of credit
risk.
Prior to the introduction of credit derivatives in the late 1990s the traditional method of managing credit risk
was via credit rationing (limiting any further transactions with a specific counterparty) and/or asset sales for
loan and bond exposures.
This was only partially effective and very inefficient. Although bank assets can be sold in the secondary
market, the riskier asset exposures that a bank is most likely to want to reduce will not necessarily have
liquid secondary markets. This is especially the case in loans; in 1996 primary loan syndication origination
in the U.S. exceeded $900 billion, whilst secondary loan market volumes were less than $45 billion 18. This
can and often leads to a bank incurring a capital loss on the asset sale (as the market prices in a discount on
the assets fair value and subsequent fire sale nature of the sale), a loss of interest income and a possibly
soured relationship with the clients concerned (potentially leading to lost future business).
Similarly it was also relatively difficult to short the market, as to do so requires that bonds are first borrowed
via the repo19 market, before they can be sold to create a short position. Not only is the corporate repo market
fairly illiquid (except for the most global names), but also these short positions have to be funded.
This left the credit risk from OTC derivative transactions (such as swaps, options and forwards); the only
way of reducing this exposure (while remaining in the market) was to set up netting agreements 20 and/or
require collateral from counterparties. Both of these options have distinctive drawbacks; netting doesnt
really reduce exposure, merely allowing an exposure to a specific counterparty to be managed better,
collateralisation does reduce counterparty risk considerably; but requires active management in itself of
posting/receiving and calling collateral (also reducing the relative attractiveness of an OTC derivative to that
of an exchange traded one).
Assignment (selling) of counterparty contracts to a willing buyer offers a more dramatic alternative of credit
reduction. However assignment tends to result in the buyer obtaining a derivative portfolio for a substantial
discount, as it can signal that the seller is either in trouble or withdrawing from the market (i.e. fire sale
prices).
17
Modigilani, F and Miller, M,. The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, June 195 8.
18
JP Morgan,. The J.P. Morgan Guide to Credit Derivatives; Risk Publications, London, 1999.
19
A repurchase agreement (repo) is an agreement between two parties whereby one party sells the other a security at a specified price with an
obligation to repurchase the security at a later date for a specified price.
20
If counterparties have multiple offsetting obligations to one another - e.g. multiple interest rate swaps or forward contracts-they can agree to net
those obligations. In the event that a counterparty defaults, the outstanding contracts are all terminated. They are marked to market and settled with a
single net payment. This technique eliminates "cherry picking" whereby a defaulting counterparty fails to make payment on its obligations, but is
legally entitled to collect on the obligations owed to it.

As you can appreciate, a bank that can not only measure and quantify their credit risk, but can also isolate the
specific aspects of credit risk embedded in financial contracts (e.g. bonds and derivatives) has a distinctive
advantage over their competitors. Why? Because a bank, which can disaggregate the various risk
components, is then able to assign each a value. In terms of credit risk, a bank can determine whether or not
they want to hold the specific credit risk associated with a financial contract (i.e. is it cheap or expensive?).
Similarly by being able to value credit risk accurately; a bank derives a more complete picture of their credit
risk exposures. Credit risk that they do not wish to hold can be transferred to other parties and likewise credit
risk that they want to hold or increase exposure to, can be purchased from the market.
Despite the obvious advantages that can be gained from actively managing credit risk, most banking
orgainisations are not doing so yet. Even in some of the worlds largest banks, credit risk management is
limited to that of a process of setting and adhering to notional exposure limits and pursuing very limited
portfolio diversification strategies. In the worst run examples, such as the German Landesbanks 21 (as just one
of numerous examples than could have been chosen) the term credit risk management was a misnomer
(rather mismanagement), although exposure limits were set and adhered to, borrowers were never
seriously monitored22. Thus as long as a counterparty line for a specific borrower was not fully utilised, bank
lending officers could continue lending regardless of the borrowers current or future debt servicing
capability. Also because of political interference (Landesbank owners are German State governments) loan
activity was frequently directed to government favoured industries and companies, on very cheap terms
(which did not incorporate a risk premium).
21
The Landesbanks lose their government guarantee in 2005 as a result of a European decree that the gurantee was a form of government subsidy. As
a result the Landesbanks credit ratings will drop from AAA to ratings determined by their respective financial performance.
22
From 1998 to 2003 WestLB lost more than EUR 1 billion annually from losses on loans and provisions for doubtful debt.

Credit Derivative Products

Credit Derivatives Defined
Credit derivatives can be defined23 as bilateral financial contracts that isolate specific aspects of credit risk
from an underlying instrument (also known as the reference asset or entity) and transfer that risk between
two parties. In so doing, credit derivatives separate the ownership and management of credit risk from other
qualitative and quantitative aspects of ownership of financial assets.
Notably the above definition, in substance captures numerous credit instruments that have been consistently
used for years; including letters of credit, guarantees and loan participations. Raising the question, why is
this relatively new group of products (credit derivatives) so significant?
The feature of credit derivatives, which distinguishes them from that of the more traditional credit
instruments, is the precision with which credit derivatives are able to isolate and transfer the component parts
of credit risk (i.e. default, spread, credit migration, restructuring) from an underlying asset, as opposed to
credit risk in its entirety.
Classification of Credit Derivatives

The classification of credit derivatives differs slightly from that of other financial derivative types, whereby
instruments are classified as either: forwards, swaps, or options. These distinctions are less clear-cut with
credit derivatives, as a credit default swap can resemble an option by way of the contingent payoff. Thus
credit derivatives are generally classified 24 on the basis of whether they are:
Credit Event Instruments
Credit Spread Instruments
Total Rate of Return Instruments
The instrument payoffs are based on reference assets, which are associated with either single names, or
multiple names. Additionally the reference asset can be either a cash instrument (such as a loan or bond) or a
synthetic instrument (such as another credit derivative).
Settlement of the contingent payment for a credit derivative can be either: cash settlement (the difference
between the par value25 and market value of the reference asset is paid by the protection seller) or by
physical delivery (the reference asset is transferred to the protection seller in return for the par value of the
asset) in the event of a credit event/spread occurring (i.e. an asset that might be valued at $0.20 after a
default, is exchanged for par).
Credit Event Instruments

These are instruments where contingent payments are made depending on the occurrence of a pre-agreed
credit event. The most commonly known is the single name credit default swap.
Instruments within this class are:

Credit Default Swaps (CDS)
Baskets (1st to default and nth to default)
Credit Indices
Credit linked notes (CLN)
Collateralised Debt Obligations (CDO)
23
JP Morgan., The J.P. Morgan Guide to Credit Derivatives; Risk Publications, London, 1999.
24
Das, S., Structured Notes and Derivative Embedded Securities, Euromoney Books, London, 1996.
25
The par or face value of a bond is generally $1.00.

Credit Default Swaps (CDS)

A credit default swap is a contract that enables two counterparties to isolate and transfer the credit event risk
from a reference asset, without transferring ownership (unless a credit event has occurred and there is
physical settlement). Credit default swaps involve a protection buyer (payer), who pays a periodic fee to a
protection seller (receiver) in exchange for a contingent payment if there is a credit event.
Credit default swaps are the largest product segment of the global credit derivatives market with
approximately 51% of credit derivative market share26.
C re d it D e fa u lt S w a p
P e r io d ic f e e ( X b p )
P r o te c tio n B u y e r P r o te c tio n S e lle r

C o n tin g e n t P a y m e n t
f o llo w in g c r e d it e v e n t
R e fe re n c e A sse t
C r e d it E v e n t
T ra n s fe r o f d e fa u lte d re fe re n c e a s s e t if p h y s ic a l
d e liv e r y
Basket Default Swaps27

A basket default swap is similar to a single asset default swap except that the underlying is a basket of assets
rather than one single asset. There are several types of basket default swaps, the most popular being first-to-
default basket default swaps. With a single asset, a credit event is usually a default of the lone asset issuer.
With a first-to-default basket swap, a credit event occurs the first time any of the issuers in the basket
defaults. Default protection against losses is provided for the first issuer to default only, as the contract
terminates following this initial default.
F irs t-to -D e fa u lt B a s k e t
P o rtfo lio M a n a g e r In v e s to r
(p ro te c tio n b u y e r) (p ro te c tio n s e lle r)
$ 3 0 m P o rtfo lio :
3 R e fe re n c e A s s e ts
of $10m each C r e d it E v e n t
d e liv e r y
T e r m in a tio n o f c o n tra c t
Nth to default 28 basket swaps provide an extension to that of first-to-default concept. Instead of the contingent
payment being determined on the first issuer to default, it can be based on the 2 nd 3rd 4th to 10th etcetera issuer
in the basket to default. The basic valuation method and payoffs remain the same as the first-to-default swap.
26
British Bankers Association., BBA Credit Derivatives Report 2003/2004.
27
Tavakoli, J., Credit Derivatives: A guide to instruments and applications, John Wiley & Sons, 1998.
28
Capital Markets Quantitative Research., Portfolio Credit Derivatives Insights A framework for managing tranche and Nth to default transactions,
The Royal Bank of Scotland, London, 2004.

Unlike a CDS, a Basket Default Swap introduces the concept of correlation. As such basket instruments are
best suited to that of investment grade reference assets, with low correlation (even better is to use reference
assets with the same credit ratings as well). The higher the correlation between the reference assets in the
basket, the greater the likelihood, that if one defaults the remaining assets will also follow suit (e.g. a basket
with three reference assets all in the car manufacturing industry; Ford, General Motors and Toyota.). Thus
the greater the correlation between a baskets reference asset components, the worse the credit protection. It
may be cheaper than buying individual credit protection on each of the reference assets, but this is at the cost
of reduced protection.
Basket structures work best when the investor seeks to gain protection to a number of reference credits that
have either very low or negative correlations (e.g. financials and miners) as the cost of obtaining credit
protection is reduced, without giving up too much of the credit protection.
Credit Indices29
Credit indices are offered as either single notes or multiple name CDS, which offer exposure to a broad
credit market and are rated. Their returns are based on the performance of a series of CDS comprising the
names in the index. Indices generally reference 25, 50 or 100 of the most popular corporate names for a
specific geographical region, investment grade or sector.
C re d it In d e x - C D S F o rm
P r o te c tio n B u y e r P r o te c tio n S e lle r

R e fe re n c e A s s e ts
d e liv e r y
R e d u c tio n o f th e In d e x n o m in a l a m o u n t b y th e
in d e x w e ig h tin g o f th e d e fa u lt re fe re n c e a s s e t
P o s t c r e d i t e v e n t t h e p r e m i u m o n t h e I n d e x is p a i d
o n t h e r e d u c e d n o m i n a l ( s u b je c t t o f u r t h e r c r e d i t
e v e n ts )
Credit derivative indices offer both liquidity and flexibility, allowing investors to take pure sectoral views
(i.e. exposure to financials or corporates only) and to place and unwind exposures rapidly. Similarly
investors are able to take negative views by shorting a single note or CDS. Similarly the inclusion of a broad
selection of credits and industry sectors provides indices with strong diversification and limited exposure to
the default of any single reference name. These benefits were previously impossible to obtain with small
transactions sizes, without buying into a fund and paying the associated fees and charges.
C re d it In d e x - N o te F o rm
C ash SPV
In v e s to r [S e lle r/M T N
In d ex sp read (X b p )
Issu e r]
C ash R e tu rn fro m
p o r tf o lio
R e fe re n c e
p o rtfo lio - 1 0 0
N am es of $1m
Is s u e r p a y s in v e s to r c a s h s e ttle m e n t a m o u n t each
I n v e s t o r s r e d e m p t i o n a m o u n t r e d u c e s b y t h e i n d e x w e ig h t i n g o f t h e
d e f a u l t r e f e r e n c e a s s e t ( i . e . P a r is n o t p a i d a t m a t u r i t y o f t h e n o t e )
P o s t c r e d i t e v e n t t h e p r e m i u m o n t h e I n d e x is p a i d o n t h e r e d u c e d
n o m in a l (s u b je c t to fu r th e r c re d it e v e n ts )
29
www.indexco.com

Indices have made a dramatic entrance to the credit derivatives market, in less than two years these products
have captured 11%30 of market share, from 0% less than two years previously.
Indeed these instruments may be a major driver of future growth of the market as a whole, as the first
exchange traded credit derivative products will be futures contracts, based on the most popular credit
derivative indices. The emergence of credit derivative futures should promote increased growth in the OTC
market as well (if it behaves as the interest rate derivatives market has).
Credit Linked Notes

A Credit Linked Note31 (CLN) is a note issuance with an embedded credit default swap. Under a CLN
structure, the coupon of the note is linked to the performance of a reference asset. It offers borrowers a hedge
against credit risk, and gives investors an enhanced yield on the note, relative to that of other note issues for
accepting the additional exposure of a specified credit event.
C re d it L in k e d N o te
H ig h G ra d e
C o lla te ra l
C ash R e tu rn
P e r io d ic f e e ( X b p ) SPV
P r o te c tio n [S e lle r/M T N
B uyer Issu e r]
C LN Coupon
C ash +
R e fe re n c e In v e s to r
A s s e ts
CLN are created through the use of a Special Purpose Vehicle32 (SPV) structure, which is collateralised with
high rated securities and is at arms-length from the deal arranger. They can be structured as either a Credit
Linked Deposit (similar to buying a collateralised CDS protection) or Credit Linked Loan.
Investors buy the notes from the SPV (the issuer) that pays a fixed or floating coupon during the life of the
note. At maturity, the investors will receive par unless the referenced asset defaults or declares bankruptcy,
in which case they receive an amount equal to the recovery rate.
The SPV enters into a default swap with the deal arranger (generally the bank that created the SPV). In case
of default, the SPV pays the dealer par minus the recovery rate in exchange for an annual fee, which is
passed on to the investor in the form of a higher yield on the notes.
The investor is exposed to both the note issuer (SPV) and to the reference asset.
Collateralised Debt Obligations33

One of the largest segments 34 of the credit derivatives market with around 16% of market share, are portfolio
products more commonly known as Collateralised Debt Obligations (CDO).
30
BBA., Credit Derivatives Report 2003/2004, London, Sep 2004.
31
http://www.investopedia.com/terms/c/creditlinkednote.asp
32
Also referred to as either: an SPC, SPE or bankruptcy-remote entity, whose operations are limited to the acquisition and financing of specific assets.
The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company
goes bankrupt.
33
www.riskglossary.com/articles/collateralized_debt_obligation.htm
34
British Bankers Association., BBA Credit Derivatives Report 2003/2004.

CDO is the general moniker given to a variety of instruments these include: Collateralised Bond Obligations
(CBO) and Collateralised Loan obligations (CLO) which respectively hold only bonds or loans. Just to make
things slightly confusing, CDO can be further distinguished by whether they are:
Balance Sheet vs. Arbitrage
Cash vs. Synthetic
Static or Managed
Cashflow or Market Value
CDO are constructed with the objective being to transfer the credit risk associated with these portfolios of
obligations. These portfolios often consist of bonds or loans held by a bank, but may also consist of
mortgages, credit card receivables and even derivatives.
A CDO is a securitisation in which a portfolio of assets as described above is transferred to a SPV, which in
turn issues multiple tranches of debt securities of varying levels of seniority and size in order to fund the
SPVs purchase of the portfolio. The tranches levels of seniority are catergorised according to their degree of
credit risk as:
Senior
Mezzanine
Subordinated/Equity
If there are defaults or the CDO's collateral otherwise under performs, scheduled payments (known as a
Waterfall) to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to
mezzanine tranches take precedence over those to subordinated/equity tranches.
C a s h C D O S tru c tu re
T ru s te e
C ash
A s s e ts tr u e s a le
S en io r N o te
O rig in a tin g SPV (A A A )
B ank C D O n o te
C ash is s u a n c e
M e z z a n in e 1
(A )
S tru c tu re s c a n h a v e 5 + tra n c h e s .
T h e e q u ity is th e f ir s t lo s s p ie c e a n d is
R e fe re n c e u s u a lly u n r a te d . M e z z a n in e 2
A s s e ts (b o n d s , S u b o r d in a tio n is m a in f o r m o f c r e d it (B B B )
e n h a n c e m e n t.
lo a n s e tc ) L e v e l o f p r o te c tio n f o r A A A n o te c a n
r a n g e f r o m 1 0 -3 0 % in c a s h f lo w C D O s .
O th e r c r e d it e n h a n c e m e n ts a r e S u b o rd in a te d
o v e r c o lla te r lis a tio n a n d e x c e s s s p r e a d . (E q u ity )
Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA (normally
represents around 70% to 90% of the notional amount of the CDO structure) and the latter receiving ratings
of B to BBB. The equity tranche is usually unrated and carries the first loss in the event of any defaults.
Ratings reflect both the credit quality of underlying collateral, as well as how much protection a given tranch
is afforded by tranches that are subordinate to it. Similarly the level of rating in effect determines the yields
paid to the various tranches. The highest rated tranches receiving the lowest yields and the equity tranche
receiving the highest yield (say LIBOR + 500 bp, whereas a AAA tranche may receive LIBOR + 20 bp). The
returns on CDO securities are dependent on the joint default performance of the assets in the collateral pool.
A CDO has a sponsoring organisation, which establishes the SPV to hold the collateral and issue securities.
Sponsors can include banks, other financial institutions or investment managers. Expenses associated with
running the SPV are subtracted from the cashflows to investors. Often, the sponsor retains the equity tranch
of a CDO (or at least a portion of it) so that it maintains a significant interest in the management of the
relationship with the obligors (and because the equity tranche can be very hard to sell).

Balance Sheet vs. Arbitrage CDO 35

These CDO correspond to the respective motivations of the sponsor.
With a Balance Sheet CDO, the sponsor is a bank or other institution that holds, or anticipates holding, loans
or debt that it wants to remove from its balance sheet in order to liberate economic or regulatory capital.
Similar to a traditional ABS 36, the CDO is a vehicle for it to do so. Assets can comprise: investment grade
and sub-investment grade term loans, revolving credit lines etc.
Arbitrage CDO are motivated by the opportunity to add value by repackaging collateral into tranches
according to investor demand for specific risk and to exploit the differences in funding costs of assets and
liabilities. This is the same motivation for most CMOs. In finance, the law of one price suggests that the
securities of a CDO should have the same market value as per its underlying collateral. In practice, this is
often not the case. Accordingly, a CDO can represent a theoretical arbitrage. Assets can comprise: high yield
or emerging market bonds, ABS/MBS37 and even other CDO.
Much of the arbitrage in an Arbitrage CDO arises from a persistent market imperfection related to the
somewhat arbitrary distinction between investment grade and sub-investment grade debt. Many institutional
investors face limits on their ability to hold sub-investment grade debt. This can take the form of regulations,
capital requirements, and investment restrictions imposed by management. Insurance companies, pension
plans, banks and mutual funds can all face some sorts of limitations. As a result, sub-investment grade debt
often trades at spreads to investment grade debt that are wider than might be explained purely by credit
considerations. With a CDO, a portfolio of sub-investment-grade debt can be repackaged into tranches, some
of which receive investment grade and even AAA ratings.
Cash vs. Synthetic CDO

Cash CDO expose investors to credit risk by actually holding collateral that is subject to default. By
comparison, a synthetic deal holds high quality or cash collateral that has little or no default risk (purchased
with proceeds of the tranche proceeds). It exposes investors to credit risk by adding credit default swaps to
the collateral. Synthetic CDO can be static or managed. They can be balance sheet or arbitrage deals.
Synthetic CDO Structure

Trustee
Portfolio CDS Cash

premium Senior Note
Originating (AAA)
SPV
Bank CDO note
Contingent issuance
payment
Mezzanine 1
Risk free (A)
Cash
cashflow
Mezzanine 2
G11 Govt (BBB)
Securities
Subordinated
(Equity)
Arbitrage synthetic deals are motivated by regulatory or practical considerations that might make a bank
want to retain ownership of debt while achieving capital relief through CDS. In this case, the sponsor has a
portfolio of obligations, called the reference portfolio. It retains that portfolio, but offloads its credit risk by
transacting CDS with the CDO.
35
Choudhry, M., Fourth-Generation CDO Structures: Credit Trading via the Managed CDO, Bloomberg Seminar, July 2002.
36
Asset Backed Securities
37
Mortgage Backed Securities

For arbitrage synthetic CDO, two advantages are

An abbreviated ramp-up period (for managed deals), and
The possibility that selling protection through CDS can be less expensive than directly buying the
underlying bonds. This is often true at the lower end of the credit spectrum.
The biggest advantage to (balance sheet or arbitrage) synthetic CDO is the fact that they don't have to be
fully funded. For a cash CDO to have credit exposure to $100 million of bonds, it must attract $100 million
in investment so it can purchase those bonds. With a synthetic CDO, a mere $150 million in high quality
collateral can support credit exposure to $1,000 million in obligations. In such a partially funded deal, the
entire $1,000 million reference portfolio is tranched, but only the lower-rated tranches are funded. In this
example, the most senior $850 million tranch would be called a super senior tranch. It might be retained by
the sponsor or sold off as a CDS. The funded piece might comprise USD $100 million of investment grade
tranches and $50 million of mezzanine and unrated tranches.
In arbitrage deals, partial funding offers higher capital relief than does full funding under the Basle capital
requirements38. For synthetic deals, it is generally less expensive to sell the super senior tranch as a CDS
than it would be to fund that tranch.
Static vs. Managed CDO39

With a Static CDO, collateral is fixed through the life of the CDO. Investors are able to assess the various
tranches of the CDO with full knowledge of what the collateral will be. The primary risk they face is credit
risk. With a managed CDO, a portfolio manager (usually the sponsor) is appointed to actively manage the
collateral of the CDO. The life of a managed deal can be divided into three phases:
1. Ramp-up which lasts about a year, during which the portfolio manager initially invests the proceeds
from sales of the CDO securities.
2. The reinvestment or revolver period lasting five or more years. The manager actively manages the
CDO's collateral, reinvesting cashflows as well as buying and selling assets.
3. In the final period, the collateral matures or is sold. Investors are paid off.
In a managed deal, investors do not know what specific assets the CDO will invest in (these assets will
change over time); at the time they purchase the CDO securities. All the investors know is the identity of the
portfolio manger and the investment guidelines that they will work under. Accordingly, investors in a
managed CDO face both credit risk, in addition to the risk of poor management. For this lack of
transparency, investors have the privilege of paying portfolio management fees. Most CDO are generally
managed deals.
Cashflow vs. Market Value CDO

A Cashflow CDO is similar to a CMO40. Cashflows from collateral are used to pay principal and interest to
investors. If such cashflows prove inadequate, principal and interest is paid to tranches according to
seniority. At any point in time, all immediate obligations to a given tranch are met before any payments are
made to the less senior tranches.
With a market value deal, principal and interest payments to investors derive from both collateral cashflows
as well as sales of collateral. Payments to tranches are not contingent on the adequacy of the collateral's
cashflows, but rather the adequacy of its market value. Should the market value of collateral drop below a
certain level; payments are suspended to the equity tranch. If it falls even further, more senior tranches are
subsequently affected. An advantage of a market value CDO is the added flexibility they afford the portfolio
manager. They are not constrained by a need to match the cashflows of collateral to those of the various
tranches.
Analysing CDO is difficult. Not only is there an entire portfolio of credits to analyse, in managed deals, an
investor won't know what collateral will be purchased. On top of this is the added complexity of the
tranching, which must also be analysed. Sophisticated portfolio credit risk models should be used. Needless
38
Basle Committee on Banking Supervision., Basle II Third Consultative Package, Overview of The NEW Basle Capital Accord, April 2003.
39
Choudhry, M., Fourth-Generation CDO Structures: Credit Trading via the Managed CDO, Bloomberg Seminar, July 2002.
40
Collateralised Mortgage Obligation.

to say, there is much potential for manipulation or abuse by sponsors. However CDO appeal to investors
because of the attractive yields they offer, but with these instruments moreso than others, it is case of caveat
emptor.
Credit Spread Instruments 41

The payoff of credit spread instruments; depend on the movement in credit spreads, regardless of the reason
for the movement. Credit spread credit derivatives enable the isolation of:
Relative credit value changes, independent of interest rates.
Trading forward credit spread expectations.
Trading the term structure of credit spreads.
Credit spread products are generally forwards or options on the future spread between two financial assets;
either to a credit spread to the risk free benchmark (absolute spread) or between two credit-sensitive assets
(relative spread).
Instruments within this class include:

Credit spread forwards (or credit spread swaps).
Credit spread options.
At present the market for such instruments is not yet particularly liquid, while credit event instruments have
gained significant and growing liquidity.
Credit Spread Forwards

The structure of a credit spread forward is that of a forward contract on the credit spread between two
reference assets. Unlike a CDS, the structure of a credit spread forward need not require periodic cashflow
exchanges, between the contract counterparties. Rather, the structure can be that of a simple forward
contract, such as a Forward Rate Agreement (FRA) 42 where there is a net cash settlement based on the
difference between the agreed spread at contracts start date and the actual spread at the contracts expiry.
Counterparties to a credit spread forward contract are obligated to make or receive payments on pre agreed
spread levels at the start of the forward contract, thus both parties have the potential to lose or make money
on the contract, dependent on the change in credit spreads at expiry.
An example may be an investor holding a corporate bond which they intend to sell in six months time,
worried that the credit quality may deteriorate (reflected by a widening of the credit spread between
corporate bonds and treasuries), affecting the price that the investor will receive on the bonds sale. A credit
spread forward can enable the investor to receive a spread of 20 bp in six months regardless of what the
actual credit spread is at that time. If credit spreads widen beyond 20 bp the investor makes a gain on the
contract, similarly if credit spreads tighten below 20 bp the investor makes a loss on the contract.
41
42
A FRA is a forward contract on interest rates.

Credit spread options

Credit spread options are similar to that of credit spread forwards with payoffs also dependent on the future
level of credit spreads, the distinguishing feature being that the option buyer has the right and not the
obligation to buy or sell the spread (depending on whether they have purchased a put or call).
As such the option seller has an unlimited loss and limited profit potential (the option premium), the option
buyer having limited downside (the option premium) and unlimited profit potential.
Credit Spread options are commonly structured to "knock-out" (i.e. expire worthless) upon a default
occurring, so that they separate the change in credit spread from the default risk.
Credit spread put options - enable the buyer the right to sell the credit spread, and benefit from an increasing
(widening) credit spread.
Credit spread call options - enable the buyer the right to buy the credit spread, and benefit from a decreasing
(tightening) credit spread.
Credit Spread Option
Option Premium at
Start Date
Protection Protection
Buyer Seller
Contingent payment at
Exercise Date
Credit Spread
Credit Spread Options - Payoffs

Payoff at Expiry
Credit Spread Call Nominal * Max (Strike - Credit Spread, 0)
Credit Spread Put Nominal * Max (Credit Spread - Strike, 0)
Long Put Long Call

Gain Gain
Credit Spreads
Strike Strike
0 0
Credit Spreads
Option Option
Premium Premium
Loss Loss

Total Return Instruments

These are instruments where the payoff depends on both the behaviour of spreads as well as on events such
as default. As such the objective of this particular type of structure is the replication of the total performance
of a reference asset (i.e. a loan or a bond).
Key features of a total return instrument are:

The investor (total return receiver) assumes all risks and cashflows of the reference asset.
The total return payer passes through all payments derived from the reference asset.
The total return receiver in return, effectively makes a payment to the payer equivalent to that of a
funding cost plus a margin.
By definition it can be argued that total return instruments are not in actual fact a credit derivatives, rather
that of financial derivatives with a credit element (in so much that the asset can default). Because of this
credit element they generally fall within the mandate of the credit derivative trading desks at investment
banks and securities brokers and as a consequence have become classified as credit derivatives.
The most popular instrument types within this category are total return and asset swaps.
Total Return Swap: (total rate of return swap) 43

A total return swap is a contract that enables an investor to obtain the cashflow benefits of owning an asset
without having to actually hold the physical asset on their balance sheet. The total return payer owns the
reference asset and pays the absolute return (income plus any capital appreciation or depreciation) of the
asset to the total return receiver in exchange for a periodic payment (LIBOR plus a fixed spread). With this
type of instrument the total return payer for all intents and purposes, is effectively lending their balance sheet
to the total return receiver.
Total Rate of Return Swap
Appreciation
Total Return
Total Return Total Return
Payer Receiver
LIBOR + X bp
Depreciation
Reference Asset
43

Asset Swap
Asset swaps44 are essentially synthetic floating rate notes. They are a tailored structure that enables an
investor to purchase a fixed rate bond (or loan) and then hedge away the interest rate risk by swapping the
fixed interest payments for floating. The investor assumes the credit risk that is economically comparable to
purchasing a floating rate note issued by the fixed rate bond issuer. There are two components to an asset
swap, the first is the fixed rate bond and the second is a fixed for floating interest rate swap of the same
maturity as the bond.
Asset Swap
Asset Purchase
Cash
Investor Issuer/Dealer
Asset
+
Coupon Swap
Fixed payment
Fixed payment
Swap
Asset Investor Counterparty
Floating payment
44
Oldfield, M., Only For the Sophisticated Investor, Euromoney-International Bond Investor, Autumn 1994.

Credit Derivative Applications

Section one introduced the concept of credit risk and the economic rationale for managing it. Section two
described the credit derivative building blocks (or key instruments) currently used in the financial markets.
This section describes how various market participants can apply credit derivative instruments to their
businesses and subsequently enhance economic performance.
The principal applications 45 of credit derivatives to enhance economic performance for organisations,
whether financial or otherwise are summarised below46:
Risk Reduction
Credit Line Management
Capital Management
Balance Sheet Management
Enhancing Yields
Accessing Markets
Market Making (trading)
Specific credit derivative end user applications are presented in the table below.
Credit Derivative User Applications

Commercial Securities Corporations Insurance Fund Mangers Government
Banks Houses Companies Bodies

Risk Reduction

Credit Line
Management

Capital
Management

Balance Sheet
Management

Enhancing
Yields

Market
Access

Market Making

Risk Reduction
Risk reduction (hedging) is driven by an organisations need or desire to reduce unnecessary credit risk
exposures. In essence it revolves around the isolation of unwanted credit risk, whether for a one-off credit
concern (such as a single deal) on ongoing business activity and the transference of that credit risk to another
party.
Credit risk exposure for an organisation can be broken down to that of:
Single name (or obligor) - such as a major supplier or counterparty.
Multiple or portfolio names - such as exposures to specific industry groups or segments.
Country exposures An organisation may have concerns that a large proportion of revenues derive
from a particular country or countries. Thus adverse economic growth or political uncertainty of
these countries can have a detrimental effect on revenues.
Generally, risk reduction requires the purchase of credit derivative protection (equivalent to being short a
bond), being that most organisations seeking to hedge exposures can be said to be long credit. This is
probably the easiest and simplest means for which to achieve the risk reduction objective (i.e. buy a CDS or
basket default swap).
45
CIFT Ltd., Masterclass in Advanced Credit Derivatives, Public Course, London, June 2004.
46
Kasapi, A., Mastering Credit Derivatives: a step-by-step guide to credit derivatives and their application, Financial Times, London, 1999.

However there are occasions where an organisation (e.g. a corporation) may be expressly prohibited47 from
dealing in financial derivatives of all but the most vanilla 48 variety. In these cases, organisations that are able
raise capital via the bond markets by issuing bonds, can remove credit risk by the use of structures such as
CLN or CDO. These structures provide the ability to directly or indirectly remove credit exposure from the
balance sheet and transfer it to a willing party.
Credit Line Management

Credit lines are the internal limits that an organisation places on its exposures to borrowers, trading partners
or traditional derivatives counterparties. Although generally more associated with banks and securities
houses, credit lines can also be applicable to corporations, fund managers and insurance companies.
Credit lines can be allocated into groupings such as, counterparty, industry segment, country and even
product type.
Unlike risk reduction, credit line management is concerned with the successful management of credit lines,
which does not necessarily mean the reduction of credit risk. Rather, the objective is to facilitate ongoing
business relationships with favoured borrowers, trading partners and counterparties.
Credit derivatives can be used in two ways to successfully manage credit lines:
The first is to reduce credit exposures via the purchase of credit derivative protection, such as CDS.
Essentially freeing up credit lines, enabling the organisation to continue business activity as normal
or even to increase it.
To increase credit exposures via the sale of credit derivative protection for credit lines where
exposure does not meet targeted levels (this could be because a bank is not active or does not have
access to a specific industry segment or market).
Where credit derivatives come into their own is that exposure to certain counterparties can be transferred to a
third counterparty (the credit protection seller) without the original counterparty otherwise aware. This is
particularly important for organisations seeking to maintain relationships with clients. If a bank is seen to be
selling its loans to a major corporation on the secondary market, that major corporation is not going to be
likely to want to continue borrowing from that bank. Worse still the corporation can decide that other
business with the bank (i.e. financial advice, financial markets products and corporate finance), will go to a
competitor that wants all their business.
Frequently loan covenants (especially in Europe) require that if the lender (i.e. bank) is to sell a loan to a
third party, they have to first obtain permission from the borrower. Using a credit derivative, the loan
exposure remains on the balance sheet of the lending organisation, yet the credit risk is removed.
In most orgainisations the notional of credit derivatives, are treated as a loan equivalent and the credit line
reduced accordingly. So if $100 million notional of credit derivative protection is purchased, this translates
to that of a $100 million reduction in the credit line utilisation (though it does create a new counterparty
exposure to the seller of the protection).
The cost of this credit line management is that potential returns from a counterparty name, or industry are
reduced slightly in the shorter term. To pay for the protection, the spread (or margin) on the business activity
is reduced. However over the medium to longer term, returns are increased as, the organisation continues
doing business as normal or even increasing it with the affected counterparty (i.e. a greater increase in
business, at a smaller margin, can be more profitable than low business volume at high margin). Of course
the organisation stays within internal credit lines, which thereby limits potential loss from a default from the
counterparty or industry.
47
Often companies prevent company officers from making transactions in certain derivative products, such as options in the hope this will avoid
potential trading losses or rogue traders. However the weakness with this type of restriction is that most sophisticated financial deri vatives can be
readily replicated synthetically, using simple products.
48
Vanilla is the term applied to derivative instruments of a very basic or simplistic nature such as futures and analytical options.

Indeed some of the first uses of credit derivatives in the late 1990s were banks hedging credit lines to major
derivative counterparties and loan exposures (i.e. buying credit protection).
Capital Management
Capital management is the process whereby management determines the business activities for which their
organisations limited capital resources are invested. Desired business activities can be either ones that offer
high returns or alternatively offer low risk to invested capital. In essence capital management can be
described as a process of balancing risk against that of reward.
Capital management is widely employed by organisations that wish to be, or remain successful. It can be
used to strategically determine which business activities/projects to pursue and also to assess potential trades
or deals with counterparties. Individual transactions, projects or deals are accepted or rejected based upon the
capital utilised and the expected profits that will be generated, measured against a stated threshold.
In the context of banking, capital is managed/allocated in two ways:

Internally as per management degree this is known as economical capital.
By external regulation and legislation (domestic and international), on a matrix based system -
known as regulatory capital.
Economic capital management
This is usually performed using sophisticated models that assess the risk and return characteristics of
potential transactions. One of the first models to emerge was the risk-adjusted return on capital (RAROC)
model, which was developed by Bankers Trust in the early 1980s. Other banks further extended the model
to that of risk-adjusted return on risk-adjusted capital (RARORAC). The idea being that the models can rank
transactions (or potential transactions) according to their expected returns adjusted in some manner for their
risk. If a transaction is above a stated threshold, it is accepted, if not it is rejected.
Credit derivatives can be used with respect to economic capital management in instances where a proposed
transaction may initially not meet the required threshold return levels, for example a proposed loan to a
favoured corporate client. Rather than reject the loan outright which could sour any client relationship, the
loan can be still be made. However the loan would incorporate a simultaneous purchase of credit derivative
protection. This in essence enables the bank to mitigate any credit risk and to also lock-in a guaranteed risk
less49 margin over the loans tenor. The locked in margin, calculated as the loans spread (including funding)
less the cost of credit protection.
Admittedly this guaranteed margin, is not going to be huge (or always possible), and is dependent on a banks
individual cost of funds. However what happens is that the risk adjusted return (although small), divided by
the risk adjusted capital use (which is going to smaller) results in a large multiple and thus clears the
threshold (e.g. in basis point terms 5/0.5 = 10).
Regulatory capital management
Regulatory capital is the requirement set by bank regulators following the Basle Accords. Basle held that for
risk-based assets (i.e. loans or bonds) a minimal proportion of the assets nominal value is to be held aside as
regulatory capital. This proportion of capital is matrix based and is dependent on the type of asset in
question.
The original 1988 Basle Accord50 provided a matrix that was applicable to both on and off balance sheet
assets.
Risk Based Capital = 8% x Nominal of the Underlying Asset x Risk Weighting x Conversion Factor (4)
As an example it required that banks hold capital equal to:

0% for OECD governments and central bank debt
20% for holdings in OECD incorporated banks
100% for Corporates
49
Guaranteed to the extent that the credit protection seller does not default, if there is a default by the borrower.
50
Basle Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, Basle, July 1988.

The levels that these weightings required were subject to much debate and discussion amongst the banks
ever since, leading to numerous updates and of course to Basle II (which is set to be implemented in
2005/2006).
In practice this means that for each $100 million nominal of bonds purchased or loans made to an OECD
incorporated bank, a bank is required to support this holding with 8% or $8 million of tier one capital (which
can be holdings of OECD government debt, cash, or equity).
So as you can see the choice of asset has an immediate economic consequence, the riskier the asset, the
greater the regulatory capital required to support it51, which in turn effectively lowers an assets potential
return (there is an opportunity cost on the regulatory capital used).
Like credit line management, credit derivatives can be used to reduce capital exposures with the purchase of
credit derivative protection and subsequent credit offsets, thus reducing regulatory capital utilisation.
Similarly assets sales, asset hedging and portfolio diversification (not just credit related) also assist in the
reduction of regulatory capital usage.
Balance sheet Management

A key feature of derivative products, which makes them as popular and versatile as they are, is there off
balance sheet nature. This off balance sheet nature, when applied specifically to credit derivatives enables an
organisation to assume unfunded credit exposures.
Prompting the question, what is so significant about whether an asset goes on or off the balance sheet? The
answer is financing. Because prior to an asset being acquired, the purchase amount (i.e. cash) has to be
obtained from somewhere. Either it comes from existing cash reserves reducing the organisations liquidity,
or the amount is borrowed resulting in interest payments (and the creation of a new liability) for the term of
the loan. The net effect is that any returns from holding the asset are subsequently reduced 52.
Thus any organisation that can replicate an on balance sheet credit exposure, off balance sheet is not only
managing their balance sheet more efficiently, but also enhancing the return on assets or capital employed
(because capital use is minimised) and subsequently increasing profitability.
Off balance sheet credit exposure can be created with the sale of credit derivative protection (providing a
long credit exposure for the seller), this provides a consistent return over the duration of the protection (as
the spread received is agreed at the initiation of the contract and does not change over time) for zero outlay.
Should the reference asset default, the credit protection seller is required to make a contingent payment to the
credit protection buyer. The loss given default (LGD) from this situation for the credit protection seller
would be identical to having had purchased the cash asset and it subsequently defaulting.
Assets can also be removed from the balance sheet through the use of cash and synthetic CDO, asset sales
and SPV53. The transfer of physical assets is generally regarded as a sale and as a consequence may not be
popular with borrowers.
Enhancing Yields
In todays rampant chase of ever increasing yields (i.e. returns) over what is currently available in the
market, credit derivatives can provide the investor with the ability to boost yields to a desired level.
Unfortunately credit derivatives instruments are not a magic bullet for yield aspirations, they are merely a
tool with which used correctly, have the potential to enhance yields over which would otherwise be available
51
Actually that is not necessarily the case, see my earlier point regarding how the Basle has lead to much debate and discussion.
52
Henry, D., Fuzzy Numbers, Business Week, European Edition, Number 3886-1216, October 4 2004.
53
Enron was but one company known for their use of SPV structures to manipulate financial statements.

in the cash credit market (i.e. corporate bonds and loans). This is because potential returns can only be
increased at the expense of magnifying risk (unless you have insider information).
It is worthwhile to note that structured financial products, (not just credit derivatives) are sold on the back of
their high yields, yet the marketing of AAA rated products such as a CLN or CDO will tend to only mention
the increased risks in the small print of the contracts (understandable really, investment bankers have to
make a living too). In fairness to investment bankers it is commonly acknowledged that the credit markets
(both for cash and derivatives) are a professional market place (retail investors cannot be involved as they
can in the equities markets) with market participants being professional investors (hedge and mutual funds,
corporate treasuries and banks and other investment banks).
Thus it is ironic that when these structured instruments go wrong 54, these so called professional investors
call in the lawyers at a moments notice and sue the investment banks that originally created these products
for them. These professionals are smart enough to buy these products when they are the current fad, yet at
the same time not smart enough understand the basic principal of investing that: greater returns can only be
obtained at the expense of greater risk.
Preamble aside, the application of credit derivative instruments with respect to enhancing yields is achieved
in three ways:
Coupon returns are exchanged for optionality payoffs. Where the coupons from a standard credit
investment are used to fund the purchase of a series of credit options, which is a common feature in
structured notes. The advantage here is that short of default, potential losses are restricted to that of
the coupon payments only, however the upside profit potential is theoretically unlimited
The investor sells credit protection. CLNs are the perfect example of this application in practice;
the boost in yields is achieved via the investor selling credit protection to an SPV. The investor
receiving the normal coupon yield, plus x basis points per annum over the duration of the CLN.
The investor can use leverage. A secondary aspect of credit derivatives being an off balance sheet
and unfunded instrument, is that they can provide an investor with more bang for their buck by
allowing credit exposures to be readily magnified to desired levels. This is achieved by increasing
the nominal on an underlying credit derivative contract, whether you are a buyer or seller of
protection. For example consider a total rate of return swap; on a nominal of $10 million the
potential returns may not excite an investor. However if the exposure is increased by a multiple of
ten, to that of a nominal $100 million suddenly potential returns increase by 1,000% (the converse is
that potential losses are also magnified by the same amount).
The measures used to enhance yields can range from the simple; such as single name products to that of the
more complex; such as baskets or other multiple name products.
These methods of enhancing yields are not inherently wrong by any means, but like all tools they should be
used appropriately and with the end users fully aware that they can result in unexpected losses. Similarly the
appropriateness of using yield-enhancing methods also requires consideration prior to investing in these
products. Should a corporate treasury be making bets on the credit performance of other reference assets?
Maybe - if they are a profit centre, no - if they are not.
Market Access
One of the many benefits of the emergence of the credit derivatives market is that it has enabled non-
traditional participants to become involved credit markets, thereby increasing liquidity to both the cash and
derivatives markets for credit.
The market for loans was once restricted primarily to financial institutions such as banks, due to the
requirement for specialist skills in assessing loan applicants, economies of scale and also regulatory
restrictions (such as the Glass-Steagal Act 55). In those days credit as a consequence was not viewed as a
54
Finance and economics editor., Credit derivatives: Russian doll, The Economist, Volume 372, Number 8394, 25 September 2004.
55
A United States 1933 Banking Act that separated commercial and investment banking activities.

tradable commodity, lenders in most cases held loans (and often corporate bond issues) until they matured
which in turn discouraged participation in the market by non-banks.
The creation of credit derivatives in the late 1990s, almost overnight, revolutionized the perspective of
credit as a tradable commodity. Because the credit risk from cash products could now be isolated, it could
then be traded in its own right and thus a new asset class was born. Better still participants could become
involved in the market without the need to be concerned with the issues and costs of aspects such as
administering loans or even dealing with the borrower. Indeed the underlying reference assets for the credit
derivatives did not even have to exist as such; they could be based on the perceived credit perception of
companies, industries or even countries.
As a result new participants became attracted to this newly emerging market, such as fund mangers,
investment bank traders, insurance companies and even sovereign nations, all looking to profit or benefit in
some way from the isolation of credit as a tradable commodity.
Some of the key constraints of the cash market for credit, which can limit organisations from participating,
include:
Corporate issuers can have preference for bank loans rather than bond issues for debt financing
(especially in Europe). This market constraint essentially removes a non-bank from participating in
the provision of credit to a desired corporate.
A lack of liquidity for specific bond issues/tranches. One of the drawbacks with numerous corporate
bond issues/tranches is that they are too small (less than $100 million). This has a tendency to make
them unattractive to a lot of potential investors, as this small size discourages an active secondary
market for the issue. The limitation of issue size is also evidenced with respect to an issuer providing
multiple tranches of a debt issue in order to construct a yield curve (i.e. issuing in key tenors such as
1, 3 5 and 10 year maturities) for investors.
A corporation may choose not to borrow (whether from banks or by issuing bonds), because they
have no need for debt capital financing.
Regulatory restrictions (such as the requirement that lenders be licensed banks) and lack of location
presence can also prevent a potential player from participating directly in a market for credit (e.g. a
specialist business bank may seek to gain exposure to agricultural sector, but not have the sales force
to achieve this).
Internal restrictions that an organisation can impose on its employees in order to prevent rogue
traders or hedging debacles. These can be can include specific; assets classes (such as debt or
equity), countries, products and often derivatives.
These constraints subsequently create an imbalance between investor demand and issuer supply, in turn
providing credit derivative products with the opportunity to address the imbalance.
How can credit derivatives be utilised to provide market access?

Creating synthetic longs - exposure to a desired reference asset can be created through the sale of
credit derivative protection (i.e. a CDS). Similarly this method also addresses the investors preferred
maturity exposure, as protection can be sold at the desired maturity.
Purchasing structured credit products For potential investors unable or unwilling to sell credit
protection an alternative is to purchase credit derivative instruments such as CLN and CDO.
Investment banks can tailor these products to specifically incorporate an investors desired credit
exposure.
Replicating the credit exposure payoff A third alternative is to replicate the desired credit
exposure though the use of a TRORS. This instrument also has the ability to potentially circumvent
internal restrictions on products, if a desired cash exposure cannot be acquired directly just replicate
the payoff via a swap.

Market Making
An important application that credit derivatives have that generally tends to be overlooked in most texts
regarding credit derivative applications is that of market making. This is where an investment bank or
securities house will make a two-way market (i.e. quoting bid and offers) for credit derivative instruments.
Other applications for credit applications that were described earlier either create investor demand for or
supply of credit protection. However this demand and supply is not often simultaneous, which without
organisations willing to make a market, would result in the credit derivatives market experiencing periods of
either excess demand for or excess supply of credit protection, huge credit spreads and most likely low
liquidity as a consequence.
Market makers by way of the fact that they are prepared to quote bid and offer prices for customers, create
depth for the market and facilitate its continued development by creating liquidity.
Market makers are primarily rewarded for this function by retaining what is known as the bid offer spread. A
quote of 100/120 for 5 year Ford protection means that the market maker is willing to pay 100 basis points
(bp) annually for protection and sell it at 120bp, the difference of 20bp (less transactions costs, i.e. brokerage
fees) is where they make their profit. Say the market maker sells protection to the customer at 100bp 56, the
market maker can then either:
Retain the bid/offer spread - closing the synthetic long credit position in the reference asset (i.e.
short CDS position) which has been created for the market maker, by doing the opposite of the
original transaction and purchasing 5 year credit protection via a credit derivatives broker or dealing
directly with another market maker.
Warehouse the exposure - maintaining a short CDS position on the reference asset and manage the
risk accordingly, the market maker would then have the view that CDS spreads for that particular
reference asset will narrow. This is known as trading and the profits from trading can be dramatic (as
can the losses).
On $5 million nominal (average market size is $5 to $10 million) the 20bp translates to $10,000 annually for
5 years (or $50,000), this income is for a single transaction, a busy market making desk at a top tier
investment bank can be doing more than 200 transactions like this a day.
The secondary reward that market makers derive from this flow business as it is called, is market
intelligence. The knowledge that market makers derive from customer flows can be harnessed to create profit
opportunities from:
Trading The knowledge of what your customers are doing and in the size they are doing it, at the
most basic level allows a market maker to front-run customer orders (if a customer sells $100m of
nominal, the market maker sells $120 million keeping the first $20 million for themselves and the
larger of the change in spreads from any move in credit spread). Similarly knowing what is driving
the customer flows, allows the market maker to strategically take views (these can be as simple or as
complex as the trader desires) on the markets future direction, with a greater probability that the
market maker (trader) will be correct.
Structuring A better understanding of the drivers behind the customer flows, creates the
opportunity for an investment banks (or securities house) structuring desk to specifically target
selected clients and tailor for them structured credit derivatives (i.e. CLN, CDO or packages so
esoteric they are not commonly known in the market) that meet a customers investing or hedging
objectives. Significantly for the investment banks, the margins (50bp to 100bp or more) for
arranging these structured products can be substantially greater than market making. The income
derived from these deals (aside from arranging) can incorporate; management fees, advisory fees,
placement fees and anything else can get away with (on top of the bid offer spread from any
underlying credit derivatives purchased or sold as part of the structure).
56
Similarly if the market maker buys credit protection at 120bp, they have the same options available, only they do the opposit e.

The Credit Derivative Market

This section provides a snapshot of the credit derivatives market as it stands today. Key aspects, which are
addressed, include:
Market size
Participants
Products
Reference assets
Relationship with other credit markets
Regulatory treatment
Market Size
The theme that is common among all the surveys is that growth of the credit derivatives market has increased
dramatically, continually surpassing the expectations of market participants. At the end of 2003 57 the global
market (excluding asset swaps) measured in terms of outstanding nominal was estimated at USD$ 3.5
trillion, an increase of 82% over the previous year. This growth is expected to continue, with the market
growing by a further 42% in 2004 to USD$ 5 trillion and reach USD$ 8.2 trillion by 2006.
The primary drivers of this growth can be attributed to the following:

A wider understanding and greater awareness of the benefits of credit protection following recent
high profile corporate and sovereign defaults (i.e. Worldcom, Enron, Parmalat, Argentina).
Increased acceptance of credit derivatives as an alternative means with which to take both long and
short credit exposures.
The higher returns on capital provided by credit derivatives compared to more traditional
investments (particularly those with funding costs) have encouraged participants to enter the market.
Improvements in risk management techniques, along with improved credit derivative valuation.
Enhancements to the original ISDA credit derivative documentation improving the clarity of
contracts, which as a result has led to less disputes following the occurrence of credit events.
The migration of employees from established institutions to the less advanced, which has broadened
the industrys participants and assisted in the standardisation of structures and documentation.
The rapid growth and increasing liquidity is to a certain extend self-reinforcing; as liquidity, price
transparency and depth of the market increase, it attracts additional participants to the market, in turn
promoting further liquidity.
57

Recent surveys released by the ISDA58 show that the credit derivatives market 59 first overtook that of the
OTC equity derivatives market at the end of the 2nd half of 2003, with USD$3.8 trillion nominal outstanding
against USD$3.4 trillion. For the 1 st half of 2004 the nominal outstanding for credit derivatives and equity
derivatives increased respectively to USD$ 5.4 trillion and USD$ 3.8 trillion.
Despite this impressive growth, the credit derivatives market is still small relative to the OTC derivatives
market as a whole. The ISDA market survey shows that credit derivatives accounted for only 3.1% of the
overall total (USD$173 trillion) of derivative transactions.
Participants
The credit derivatives market can be essentially divided into three segments; buyers of protection, sellers of
protection and intermediaries.
Commercial banks are by far the largest buyers with over 50% of global market share 60. The primary drivers
behind the banks usage of credit derivatives are twofold. The first is that they provide an efficient way of
reducing their credit exposures, as it is frequently cheaper (and definitely easier) than securitising debt or
selling loans on the secondary market, and does not affect the relationship with borrowers. The second
reason is regulatory; the current capital requirement on investment grade corporate debt is higher than the
internally imposed economic capital requirements, thereby providing banks with an incentive to transfer the
risk to entities operating under a different capital regime.
Credit Derivative Market Participants

Buyers Sellers
End of: 2001 2004 2001 2004
(forecasted) (forecasted)
Commercial Banks 52% 51% 39% 32%
Securities Houses 21% 16% 16% 15%
Fund Managers 15% 16% 10% 16%
Insurance Companies 6% 8% 33% 33%
Corporations 4% 7% 2% 4%
Government Bodies 2% 2% 0% 0%
Source: BBA Credit Derivatives Report 2001/2002
However, credit derivatives are not yet widely spread throughout the banking sector, largely remaining the
province of the larger banks. Counterparty risk is heavily concentrated among the top 10 global banks and
broker dealers, which together account for around 70% of all credit derivatives transactions 61. Indeed JP
Morgan Chase is a counterparty in just over 50% of credit derivative transactions in the US 62. As the market
develops, this concentration among the top ten banks is expected to reduce significantly (only a couple of
years ago the top 10 had a 99% share of the market).
Top 10 Counterparties 2003

Name
1 JP Morgan Chase
2 Deutsche Bank
3 Goldman Sachs
4 Morgan Stanley
5 Merrill Lynch
6 Credit Suisse First Boston
7 UBS
8 Lehman Brothers
9 Citigroup
10 Bear Sterns
Source: Fitch Ratings
58
ISDA., ISDA Market Survey 1987 2004 (1H), New York , 22 Sep 2004.
59
The ISDA only includes credit default swaps in their survey, thereby understating the true size of the credit derivatives mark et.
60
61
Fitch Ratings., Global Credit Derivatives: A Qualified Success, 24 Sep 2003.
62
OCC., OCC Bank Derivatives Report Second Quarter 2004, Administrator of National Banks, Washington DC, 2004.

Banks and securities houses also play the role of intermediaries in the market, providing liquidity for the
market via trading or through the creation of credit structures (both for buyers and sellers). Credit trading has
become an important new source of profit in its own right (see the section on applications) and many banks
and securities houses are now entering this market. Indeed many are combining their CDS and corporate
bond trading desks (a lot of CDS traders are ex corporate bond traders) in order to encourage traders in
identifying arbitrage opportunities between the two markets. Intermediaries are also using credit derivatives
as a means of managing credit risk arising from OTC derivative transactions (i.e. interest rate swaps, a
practice known as line management).
The major net sellers of protection are insurance companies, with several companies devoting substantial
resources to underpin this business (especially financial guarantors). Estimates suggest that the insurance
companies involvement in the market has enabled banks to transfer over USD 260 billion of credit risk 63.
There are a number of reasons for this involvement: 64
Insurance companies generally calculate capital based upon premium, whereas banks calculate it on
nominal value. Transfer of credit risk can represent a net capital saving across the two sectors. This
may explain why the most highly rated insurers such as monolines are prepared to invest in large
amounts of low premium, senior and super senior tranches.
Credit liabilities represent a major, relatively new, asset class that can enable insurance companies to
diversify their normal investment risks.
Insurance companies generally have a broad cultural tolerance for difficult risk. This tolerance is
assisted by the fact that at the moment insurers can hold risks for long periods of time without
having to mark-to-market65.
Insurance pricing is based upon long-run actuarial assumptions, rather than the much more short-
term dynamic bank pricing, so it is possible than in a transaction both the buyer and seller achieve a
bargain. This may explain why several international Property & Casualty insurers and reinsurers
have been buying mezzanine and principal-protected equity tranches.
The great prominence of the insurers may also explain the rapid growth of portfolio transactions. Many
insurance companies are restricted in their use of derivatives, but are able to invest in credit linked securities
and CDO tranches along with their normal asset classes.
Fitch66 also discovered that European regional banks such as the German Landesbanks were major sellers of
protection, using the exposures to enhance the low yields that are otherwise available in their low margin
domestic markets.
Fund managers are active on both sides of the market, buying protection on their investments as well as, to a
lesser degree, enhancing yield by purchasing tranches. The nature of the fund tends (i.e. whether a pension,
mutual or hedge fund) to dictate the seniority of the investment, with pension funds buying senior tranches
and hedge funds the mezzanine and equity tranches. Hedge funds are also becoming increasingly active in
trading credit derivatives (in particular credit structure arbitrage - which is the arbitrage of; cash vs. credit
derivatives vs. the equity of a reference asset).
Non-financial corporations are generally net buyers of protection, but their direct activity in the market has
been limited to date, with only a handful of large multi national corporations involved. There are, however a
number of credit derivative applications that can be readily adapted for use by corporations. Examples may
be a company using a CDS to buy protection against credit extended to customers or against a major supplier
defaulting. Successful marketing of the advantages of credit derivatives by the investment banks to
corporations is likely to result in this area of the market increasing activity.
Participation from government bodies and supranationals (i.e. World Bank and IMF) has been very limited.
Similar to corporations, these entities are natural buyers of credit protection examples may include;
mitigating the credit risk of major long term project financing (e.g. construction of bridges and roads) or an
Export Development Agency (EDA) reducing the credit risk form holding emerging market sovereign
63
Fitch Ratings., Global Credit Derivatives Survey: Single-Name CDS Fuel Growth, 7 Sep 2004.
64
65
Daily valuation of an asset at current market prices, leading to unrealised profit and losses.
66

exposures to markets they wish to develop for export. It is surprising that these participants have not been
more active in the market.
Retail investors are currently precluded from the credit derivatives market entirely, by way of its OTC
nature. The absence of any retail investor credit derivative products is due principally to the fact the market
is so new. Currently there are a number of exchanges looking to list credit derivative futures contracts on
credit indices, of which the Singapore Exchange will launch the first in late 2004, based on the Asian Trax -
X indexes67. Such a development makes the market more accessible to small participants such as retail
investors and smaller banks, owing to the small size of contracts and the absence of counterparty risk (due to
margin and daily margin requirements of open futures positions). Credit derivative traders expect that credit
derivative futures will result in greater transparency to the market as a whole (as prices are easily
disseminated) thereby improving liquidity and subsequently growing the market further.
Products
The latest BBA Credit Derivative report 68 has shown that the most popular credit derivative product by
market share continues to be credit default swaps with 51% of the market in 2003, up from 45% in 2001.
One of the key drivers behind the popularity of CDS is their use by both intermediaries and investors to delta
hedge their portfolio credit derivative exposures69, thus as portfolio products experience growth so do CDS.
The BBA note that one of the main developments since the previous report in 2001 was the introduction of
credit derivative indices, which already accounted for 11% of the market at the end of 2003. Expectations are
that this market share will further increase to 17% by 2006.
Global Market Share of Credit Derivatives Products 2003
Credit Default Swaps

51.0% Portfolio/Synthetic CDOs
16.0% Indices
Credit Linked Notes
Asset Swaps
Total Return Swaps
Basket Products
11.0% Credit Spread Products
1.0% Equity Linked Products
3.5% 3.5% 7.0%
3.5%
3.5%
Source: BBA Credit Derivatives Report 2003/2004
With the exception of Credit linked notes, no other product type captured more than 7% market share in
2003 and were not predicted to do so in the near future.
67
Trinephi, M., Credit indexes: Exchanges look to futures, Asiarisk, Apr 2004.
68
69

Reference Assets
Credit protection written on sovereign names were prevalent as reference assets in the early days of the
credit derivatives market, however the share of sovereigns as reference assets has declined from over 50% in
1997 to less than 10% in 2003 70. In contrast, corporate names have become the most common, accounting
for 65% of all reference assets in 200371. This growth in corporate names as reference assets is reflective of
the rapid growth of the corporate bond market from the mid 1990s 72. Similarly the notable reduction in debt
out-standings by a number of corporate issuers (i.e. calling bonds) over the past year is most likely to
maintain the dominance of corporate names as the majority reference assets. This is due to market
participants switching from cash to credit derivatives in to maintain credit exposure to specific corporate
names.
Global Reference Assets by Type 2003
Corporate Sovereign
65% 6%
Financials
17%
Asset Backed
Other Securities
Source: Fitch Ratings 7% 5%
The number of actively traded corporate names is around 500 to 1,000, although trades have occurred on up
to 2000 names73. The majority of these companies are rated by the major agencies with approximately 82%
investment grade (BBB ratings and above), though as the market develops further it is likely that the
percentage of sub-investment grade reference assets will increase. The rationale behind a move to lower
credit grade reference assets intuitively makes sense, as the demand for credit protection will increasingly be
for riskier reference assets 74. Similarly Fitch75 note that the reduction in demand for senior and super senior
protection (CDO), combined with the launch of high yield CDS indices, provide a further explanation for
this ratings shift. Hedge funds are also thought to have increased interest in trading high yield names. These
factors have contributed to the increase of sub-investment grade credit exposures to 18% in 2003, up from
8% in 200276.
Global Credit Derivative Exposures by Rating 2003

AA
AAA
10%
17%
A
25%
Sub Investment Grade

18%
BBB
Source: Fitch Ratings 30%
70
Nomura Fixed Income Research., Credit Default Swap (CDS) Primer, New York, 12 May 2004.
71
72
73
74
Unless an investor is very risk adverse, why buy credit protection against a reference asset that has a very low probability of default?
75
76

The most actively traded reference assets for the month of July 2004 were: Ford Motor Co, General Motors,
Altria Group, Daimler Chrysler, General Electric, Verizon Communications, Duke Energy Corp, MBIA
Insurance, Eastman Kodak and Rolls Royce PLC 77.
Contract Size & Maturity

One of the key features distinguishing OTC derivatives from their exchange traded (ET) brethren is the fact
that contract size and maturities are non-standardised. Like other OTC derivatives, credit derivatives have no
limit to either the size or maturity of a specific contract. However, the average size of contracts traded ranges
from a nominal of USD$5 to USD$20 million, with the USD as the most favoured currency denomination.
Maturity of contracts ranges from 1 to 10 years, with the 5-year maturity being the most popular tenor. As
the market continues to increase both its liquidity and depth, it is expected that activity in other tenors
(especially around the five-year tenor) will experience notable increases.
Credit Default Swap Spreads78

The premium paid for protection by a buyer to the seller is called a CDS spread It is quoted in basis points
per annum of the contracts nominal value and is usually paid quarterly. It should be noted that the spread
quoted on a CDS is NOT the same as the credit spread of a corporate bond to a government bond. The CDS
spread is the annual price of protection for a reference asset and not based on any risk-free bond or any
benchmark interest rates (think of it in a similar capacity as an annual insurance premium, which is fixed for
a stated period).
For example, the 5-year default swap quote for Ford Motor Corp (the top reference entity) is 168.77/172.66
as at 8 October 200479. This means that a protection buyer of Ford on a nominal value of USD$ 10 million
would pay 172.66 basis points, or USD$ 43,165 every quarter until expiry 80 of the contract, as the premium
for the protection received.
Relationship with other Credit Markets

Credit derivatives have fostered improved liquidity in the cash credit markets by making it easier to access a
diversified portfolio of names and, when desirable, actively short credit risk. Originators of credit, as a result,
are less capacity constrained in terms of industry and obligor exposures. Moreover, the market does appear
to be moving toward greater liquidity and diversification as more reference entities are actively traded 81.
Similarly the credit derivatives market leads to a convergence in prices on loans, bonds, asset swaps and
CDS. As differences in relative credit spreads (funding costs aside) allow traders to arbitrage the market, in
turn removing pricing anomalies. Prices on these products are unlikely to converge completely: as loans may
contain clauses and covenants that allow lenders to take pre-emptive action to protect their exposure more
easily than bondholders or banks may under price loans in order to attract future business with a borrower.
Similarly there are the funding costs to consider on cash products, whereas credit derivatives are unfunded
(the exception being structures such as CDO and CLN).
There is now anecdotal evidence that the credit derivatives market is now leading the cash market, as CDO
structures hedged with CDS are having a greater effect on the current general tightening of credit spreads of
cash products than that of traditional cash market spread drivers.
Similarly the growth of structured credit derivative products is essentially reinforcing the expansion of the
credit derivatives market as a whole. This is because traders are hedging these structures with vanilla credit
derivative products such as CDS and credit indices.
77
www.fitchratings.com/corporate/sectors/crdt_drvtvs/cdx_index.cfm
78
79
Bloomberg L.P., CDSD (Ford), 11 Oct 2004.
80
Unless prior to expiry, the protection buyer closes out the contract with the originating seller or the reference entity defaults.
81

Regulatory Treatment of Credit Derivatives 82

Regulatory treatment of risk transfer by banks using credit derivatives has been and remains important to the
growth of the market. It is not a mere coincidence that more CDO transactions occur towards the end of the
year, prior to financial and regulatory reporting dates. Bank regulators presently do not have a common
internationally agreed approach to the affects of credit derivatives on bank capital requirements.
Consequently making it possible for banks to arbitrage regulatory regimes and locate units in countries that
provide favourable treatment. Similarly it is possible for institutions, especially insurers and hedge funds
(which are not subject to the same regulation as banks) to create significant concentrations of correlated
credit risk without the necessity to identify theses positions to regulators.
Changes to the Basel Accord83 include a standardised treatment of credit derivatives. Protection provided by
non-banks of high credit quality (such as insurers) can reduce the risk weight of a banks underlying
exposure, provided the credit derivative includes defined credit events that mirror the ISDA definitions.
There are two approaches available to banks calculating their capital requirements:
Standardised approach based on external ratings.
Internal ratings approach (IRB) based on internal ratings set by the lending bank with reference to
the probability of default.
For protection buyers, the banking book treatment for exposures protected using the standardised approach
would be calculated with the following formula:
r * ( w r ) (1 w) g (5)
where
r* = effective risk weight of the position, taking into account the risk reduction from the CDS
r = risk weight of the underlying obligor
w = residual risk factor, set a t 0.15 for credit derivatives
g = risk weight of the protection provider.
The risk weights of the obligor (r) and the protection seller (g) will depend on their respective external
ratings.
Consider for example a AAA rated insurer (20% weighting) selling protection on an underlying exposure
which was a B rated corporate (100% weighted), a bank with a required 8% capital ratio would see its capital
requirement on an unprotected $100 million exposure, decrease from $8 million to $2.56 million with the
inclusion of CDS protection.
100% 8% $100m $8m (unprotected exposure)
(15% 100%) (85% 20%) 32% (the effective risk weight)
to 32% 8% $100m $2.56m (final capital requirement for exposure protected with a CDS)
The (w) factor is intended to capture any residual risk that protection purchased using CDS might be
unenforceable, leaving the bank with an unhedged exposure to the underlying obligor.
A similar formula, using probability of default rather than risk weights, is proposed for banks using the IRB
approach. Banks using the Advanced IRB are permitted to use their own methodology to estimate default
probability for exposures protected by CDS.
For the trading book, Basle II also has an affect on the specific capital charge applied to trading book
positions hedged with credit derivatives. In this case the process is much simpler, allowing an 80% offset for
positions hedged using CDS or CLN, providing the reference asset, maturity and currency of the underlying
position are an exact match. The offset is applied to the side of the hedged transaction with the higher capital
charge. In instances whereby the reference asset is identical and only the maturity and currencies are
mismatched, only the higher of the specific risk capital charges for the two sides of the hedge would apply.
82
Rule, D., The credit derivatives market: its development and possible implications for financial stability Bank of England- Financial Stability
Review, Jun 2001.
83
Basle Committee on Banking Supervision, Consultative Document: Overview of the New Basel Capital Accord, Basle, Apr 2003.

Credit Default Swap Valuation

This section covering the pricing/valuation84 of CDS is an area that much of the research and literature
published on the subject has a tendency to unnecessarily overcomplicate. Like many financial derivatives
instruments, the valuation of CDS is essentially a case of deriving the present value of actual and possible
cashflows and arriving at a net present value. Valuation for this section focuses entirely on that of CDS
despite the numerous credit derivative products that exist today. The rationale behind this is that CDS are the
leading credit derivative product (in market share and liquidity) and as a consequence they are a building
block for many other credit derivative products.
Specific areas that are addressed include the following:

Key pricing variables
Default probabilities and recovery rates
Intuition behind CDS valuation
With respect to valuation, three popular approaches are examined which include:
Back of envelope
Replication
Modeling
In order to move away from pure theory to that of practical application, an example of CDS valuation using
the JP Morgan model 85 is provided. Unlike many academic papers on CDS pricing, this example is presented
in an easily comprehensible format (i.e. it can be readily replicated by the reader), using current market data.
Key Pricing Variables 86

When valuing any type of financial instrument, it is absolutely crucial to understand not only the variables
going into a methodology (and why), but also what assumptions (if any) the methodology makes, for it to be
valid. In essence a participant should know what drives a specific methodology or model, it sounds obvious
but there are a lot of people that trade products using methodologies and models like a black box (i.e. they
dont know what input variables drive the valuation output).
So how do you determine how much CDS protection should cost? First, define the variables that are
incorporated into the methodology used, and then understand which variables are excluded (and why).
The most important variables for valuing a CDS are.

Probability of default and the recovery rate are somewhat subjective and can be obtained in
numerous ways (which are described in detail later).
Correlation between the reference asset(s) and the protection seller is important, being that
buying protection on a reference asset that is highly correlated with the protection seller is in essence
like giving away cash and quite stupid (e.g. buying protection on the US Investment bank JP Morgan
from JP Morgan). The higher the correlation between the two, the greater the likelihood that if the
reference asset defaults, so too does the protection seller. Nevertheless many models make the
assumption that the correlation is zero and can thus be ignored because (a) it simplifies the model
and (b) lessons in stupidity would have to be taken to make such a mistake. If correlation is
incorporated into a model then so too must the joint probabilities of default.
Maturity of the contract is the most simple, being that it is purely objective. Yet the maturity of
protection is a major determinant in the final value of a CDS (intuitively a long-dated CDS is going
to be more expensive than a short-dated one).
84
A distinction drawn between that of the CDS price and its value, is that the price is the CDS fair value (i.e. Par CDS spread, in basis points) and
the value is the present value of the CDS in dollar terms. However both terms can be readily interchanged.
85
JP Morgan., Par Credit Default Swap Spread Approximation from Default Probabilities; JP Morgan Inc. Credit Derivatives, New York, Oct 24,
2001.
86

Other variables, which require some level of consideration, yet are generally overlooked in most quantitative
valuation methodologies are:
Demand and supply for credit protection has a direct bearing on current CDS par spreads (high
demand causes CDS par spreads to widen, whereas excess supply causes CDS par spreads to
narrow) and subsequently their values, yet by their nature are very hard to model in any quantitative
form.
Economic research can be utilised to assess whether or not the reference assets credit quality will
improve or deteriorate (assuming of cause that the research is any good) and thus provide and idea of
the future direction of CDS spreads.
Default Probabilities and Recovery Rates
Central to most CDS valuation models are the default probabilities and the expected recovery rate, as
without these key variables any model valuation is going to close useless. It can be argued that the key
distinction between the various types of models available for valuing CDS, are in the methods utilised to
determine the default probabilities (and to a lesser extent the recovery rate).
There are no hard and fast rules to obtaining either default probabilities or recovery rates. Methodologies
available range from the simple to the highly complex, each with their own inherent pros and cons. The most
common of which are:
Historical data - This method is arguably the most basic, both default probabilities and recovery
rates can be taken from published historical data from the many rating agencies (see the section
Introducing Credit Risk for an example). Nothing easier, however there are pitfalls with this method:
the data is historical and does not necessarily predict future performance, data may not be specific
enough with the user perhaps having to use an industry sector as a proxy for their reference asset
(especially so for sovereigns) - resulting in CDS valuations based on an industry sector rather than
that of a specific reference asset (i.e. incorrect values). Even if this data is obtained from proprietary
databases, the same drawbacks apply.
Transition ratings - similar to using historical data (see the section Introducing Credit Risk for an
example), transition ratings can be obtained from publicly available data or from proprietary
databases (or even a combination of both). However whereas the historical data method uses
historical default events per industry sector, transition ratings focus on the likelihood of a reference
assets credit rating changing. From here the user can apply the historical default rates for a specific
credit rating and multiply by the probability of a change in each rating (i.e. using matrix algebra).
CDS Spreads Given a curve of par CDS spreads (i.e. CDS spreads of varying maturities) each
with a net present value of zero, an algorithm can be constructed that calculates the implied default
probability by using a bootstrap procedure. This particular method is probably the most accurate of
the methodologies available, as it is the most reflective of market sentiment. The drawback is that it
is only useful for the most liquid of the underlying reference names (i.e. the top 100) for CDS. A less
popular reference name means that either a proxy default curve is calculated or that the default curve
is implied from illiquid spreads (and is wrong).
Issuer (credit risky) yield curves Assuming that the credit spreads between risky bonds and risk-
free bonds are purely reflective of the likelihood of default - then this is an awesome method to use.
As market sentiment changes this is immediately shown in a change in the credit spread, and thus
default probability. Unfortunately credit spreads do not just reflect the market view on an underlying
bonds default probability87, they also incorporate factors such as: supply and demand, tax, liquidity,
interest rates and the bonds level of seniority (which affects any expected recovery rate). This
approach also relies on obtaining a recovery rate from some other source (see historical data or
transition ratings matrices). Despite the drawbacks, examples of Hulls methodologies for deriving
default probabilities from issuer yield curves are demonstrated in the following section.
Use of equity prices The above methodologies are all generally reliant to at least some degree on a
companys credit rating. Because ratings agencies generally only review credit ratings annually, any
ratings changes (unless a company is under a credit watch) follow after the market has already
87
Delianeis, G. and Geske, R., The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity and Market Factors,
University of California, Los Angeles, 2001

digested any pertinent information that will affect a companys default potential (lawsuits, losses
etc). Leading many market analysts and academics to argue that equity prices are more relevant for
deriving default probabilities. The Merton88 model is a derivation of the well-established Black-
Scholes model89 and shares the same assumptions. The model was originally proposed as a means of
assessing credit risk by characterising a companys equity as a call option on its assets. The equity in
a firm is a residual claim; equity holders receive the residual of the cashflows left after other
financial claim-holders (e.g. lenders or accounts payable) have been satisfied. On liquidation the
same principle applies, equity holders receive the balance of any cash or assets once all outstanding
debts and other financial claims are paid off. Thus equity can then be viewed as a call option on the
firm, whereby exercising the option requires the firm to be liquidated and the face value of the debt
(treated as the exercise price) to be paid off. The firm is the underlying asset and the option expires
on maturity of the debt. The default probability is obtained by calculating the equation N (d2 ) 90.
The intuition behind the model is perfectly sound; unfortunately the models assumptions (such as a
single debt issue) and its simplicity require that the model be modified significantly before it can
provide any tangible use. KMV91 is a big exponent of this type of technique; they apply a
transformation to the probabilities derived from Mertons model to produce default probability
estimates, which in turn are calibrated into real default probabilities using monotonic mapping
based on historical experience.
Probability of Default Assuming No Recovery 92
Hull is a popular reference for both professional and aspiring professionals in the financial markets. Thus it
is appropriate to demonstrate the derivation of default probabilities from issuer yield curves using Hulls
methodology, because it is commonly accepted and widely known.
where
y*(T) is the yield on a T-year risk free zero coupon bond
y(T) is the yield on a T-year corporate zero-coupon bond
Q(T) is the probability that the corporation will default between time zero and time T
Using the equations (1) and (2) the value of a T-year risk free zero coupon and a similar corporate bond with
principal of $1is e y and e y (T )T . The expected loss from default is therefore
*
(T )T
e y* ( T ) T
e y (T )T
Making an assumption that nothing will be recovered from the corporate defaulting, the calculation of Q(T)
is quite easy. There is a probability Q(T) that the corporate bond will be worth zero at maturity and a
probability of 1-Q(T) that it will be worth 1. The bonds value is then
Q(T ) 0 1 Q(T ) e y* (T )
1 Q(T ) e y (T )
*
The yield on the bond is y(T), such that
e y (T )T 1 Q(T ) e y (T )T
*
meaning that
e y (T )T e y (T )T
*
Q(T )
e y (T )T
*
reducing to
88
Merton, R., On the Pricing of Corporate Debt: The Risk Structure of Interest Rates; Journal of Finance, Vol. 29, pgs 449-470, 1974.
89
Black, F. and Scholes, M., The Pricing of Options and Corporate Liabilities; Journal of Political Economy, Vol. 81, pgs 81 -98, 1973.
90
See Merton for a full break down of the model and its inputs.
91
http://www.kmv.com
92
Hull, J., Options, Futures and Other Derivatives: Prentice Hall, 5th Edition, 2000.

y (T ) y* (T ) T
Q(T ) 1 e
(6)
This methodology is demonstrated using current market data93 in the following table.
Probabilities of Default Assuming No Recovery
Maturity Benchmark Corporate Expected Default
zero rate zero rate default loss probability
(years) (%) (%) (%) in year (%)
1 2.53 3.38 0.8489 0.8489
2 2.93 4.12 2.3653 1.5164
3 3.25 4.81 4.5555 2.1902
4 3.53 5.41 7.2370 2.6815
5 3.77 5.99 10.4852 3.2482
Probability of Default Assuming Recovery

The assumption that nothing will be recovered in the event of default is not particularly realistic. Upon
bankruptcy, creditors owed money by the defaulting company file claims against the companys assets. The
liquidator then sells these assets and the proceeds are used to pay off as much of the claims as possible.
These claims are categorised by seniority of the debt for which the more senior the debt, the greater the
priority of those debt holders claims (i.e. senior bond holders get paid before more junior debt holders, and
equity holders only receive any remaining residual amounts after the debt holders have been paid) Therefore
the above equations can be thought of as that of a primer to default probabilities incorporating a recovery
rate, which follows.
Hull and White94 define the recovery rate as the proportion of claimed amount received in the event of a
default. Making the assumption that the claimed amount for a bond is the no-default value of the bond, the
calculation of the default probability of default is simplified. The same notation as the earlier equation (6) is
used with the addition of R as the expected recovery rate. Thus in the event of a default the bondholder
receives a percentage (R) of the bonds no-default value. If there is no default, the bondholder receives 1 (on
principal of $1). The bonds no-default value is e y
*
(T )T
and the probability of a default is Q(T)
The value of the bond is thus
1 Q(T )100e y (T )T Q(T )100Re y*(T )

so that
100e y (T ) 1 Q(T )100e y*(T )T Q(T )100Re y*(T )T

which gives
e y*(T )T e y (T )T
Q(T )
(1 R)e y*(T )T
which can be reduced to
1 e
y (T ) y*(T )T
Q(T )
1 R (7)
93
Bloomberg L.P., SWDF, 27 Oct 2004. Benchmark and Corporate zero curves were derived from their respective par curves (i.e. discount rates from
par curves were used to derive the respective zero curves)
94
Hull, J., Options, Futures and Other Derivatives: Prentice Hall, 5 th Edition, 2000.

This is demonstrated using the same financial data as previously in the following table.
Probabilities of Default with 40% Recovery
Maturity Benchmark Corporate Expected Default
zero rate zero rate default loss probability
(years) (%) (%) (%) in year (%)
1 2.53 3.38 1.4148 1.4148
2 2.93 4.12 3.9422 2.5274
3 3.25 4.81 7.5925 3.6503
4 3.53 5.41 12.0617 4.4692
5 3.77 5.99 17.4753 5.4136
Note that in calculating the default probability with a recovery amount, it results in a default probability that
is higher than if no recovery amount is assumed. Which is a slight problem, as the probability of default
should in theory be independent of the expected recovery amount (as recovery occurs after a default).
Hazard Rates95
Much of the literature on CDS valuation refers to hazard rates rather than that of default probability density
(i.e. default probability). This can potentially result in confusion for the practitioner unless the relationship
between the two is defined.
The hazard rate h(t) at time t is defined so that h(t)dt is the probability of default between time t and t + dt,
conditional on no earlier default (i.e. h(t)dt is the probability of default between time t and time t + dt
conditional on no default between time zero and time t). The default probability density, q(t) is defined such
that q(t)dt is the unconditional probability of default between times t and t + dt as seen at time zero.
Either h(t) or q(t) can be utilised in describing default probabilities. They provide equivalent information and
the relationship between the two is
t
q(t ) h(t )e 0
h ( ) d
(8)
The table below shows the relationship between that of hazard rates and default probabilities.
Hazard Rates Vs. Probabilities of Default Assuming (No Recovery)

Maturity Benchmark Corporate Default Hazard
zero rate zero rate probability Rates
(years) (%) (%) in year (%) (%)
1 2.53 3.38 0.8489 0.8562
2 2.93 4.12 1.5164 1.5532
3 3.25 4.81 2.1902 2.2947
4 3.53 5.41 2.6815 2.8907
5 3.77 5.99 3.2482 3.6287
Intuition behind CDS Pricing

A CDS consists of two legs (like an interest rate swap), a fixed leg and a contingent leg. On the fixed leg
side, the protection buyer (payer) makes a series of fixed periodic 96 payments of CDS premium until the
earlier of; contract maturity or default of the reference asset. With the contingent leg, the protection seller
(receiver) makes a single payment, only in the event of the reference asset defaulting (hence the term
contingent).
95
96
Generally quarterly payments, but they can be monthly, semi annual or annual payments.

The net present value (NPV) of the CDS is simply the algebraic sum of the present values of its two
respective legs. Again like an interest rate swap, at inception the market premium on a CDS is set such that
the value is set to zero.
Value of CDS = PV [contingent leg] PV [fixed leg] (9)
An illustration of the cashflows of a CDS is shown below.
Credit Default Swap Cashflows

(a) no default
X bp X bp X bp X bp X bp
Protection buyer
t0 t1 t2 t3 t4 t5
Protection seller
(b) default
X bp X bp X bp X bp
Protection buyer
t0 t1 t2 t3 t4 t5
Protection seller
(1-R)
The payment made by the protection seller following a default by the reference asset is usually (1-R), where
R is defined as the recovery rate of the reference asset, multiplied by the nominal amount of the CDS
contract. As an example, if the expected recovery rate on a reference asset is 40% of its par value, then
following default the protection seller will pay 60% of the remaining value.
Back of Envelope Valuation97

A quick and dirty way of obtaining an approximate valuation for an existing CDS is to use a back of
envelope method. This approach although not particularly accurate is useful in capturing the flavour of a
change in CDS value following a move in CDS spreads (and time) and also demonstrates that you do not
need a Doctorate to get a quick valuation for a CDS.
What is the value of the following CDS?

Bought protection
4 years to maturity
Nominal is USD$10 million
Current CDS spread is 110 bp
Dealt CDS spread was 100bp
What is the hedge of the CDS?
The holder of the above CDS can hedge themselves by selling protection now. In the situation whereby the
existing CDS was not hedging any other credit exposures, the profit from this strategy is the current CDS
spread less the initial CDS spread (10 bp), multiplied by both the remaining maturity and the nominal of the
contract.
PV = (Current CDS spread Dealt CDs spread) x remaining maturity x nominal (10)
PV = (110-100) x 4 x $10 million
PV = 45 bp x $10 million
PV = $45,000
As such this approach has the PV equal to the total income over the remaining life of the trade and its hedge.
97

Unfortunately the above method is only useful where there is a low probability of default and changes in
CDS spreads are fairly low as contingent payments are not incorporated in the approach.
Replication Approach to Valuation98

This methodology values a CDS by evaluating the cost of a portfolio that replicates the cashflows/payoffs
arsing from the CDS. The approach by Duffee is summarised in the table below.
Short Default Protection = Long Risky Bond + Short Risk-free Bond

(sell CDS)
Long Default Protection = Short Risky Bond + Long Risk-free Bond
(buy CDS)
However although correct, why use bonds when asset swaps are a more efficient alternative?
Asset swaps99
Because a CDS can be synthetically replicated, CDS valuation does not have to be model dependent.
Similarly it is a reasonable assumption to consider that the underlying cash market is efficient, on average.
Asset swaps provide a pricing source for valuing default risk. Asset swaps provide a context for relative
value, as reference assets have transparent prices. This approach also makes it possible to tie expectations
about cash bond pricing to expectations about the valuation of a CDS an important consideration when
constructing any form of hedging.
The following picture shows how a CDS can be replicated. In this example the investor is selling credit
default protection (i.e. equivalent to a short CDS).
R e p lic a tin g C D S E x p o s u re p ro te c tio n s e lle r

C o rp o ra te
B ond
P r in c ip a l T + C o rp o ra te s p re a d
T + S w ap sp read
In v e s to r Sw ap
M a rk e t
L ( L ib o r )
C o lla te r a l
R e p o ra te (L - X )
P r in c ip a l * ( 1 h a ir c u t)
R epo
M a rk e t
In replicating the trade the investor undertakes the following:

Purchases a cash bond with a spread T + Sc for par.
Pays fixed on an interest rate swap (T + Ss) with the same maturity as that of the cash bond, and
receives Libor.
Finances the position (i.e. the purchase of the cash bond) in the repo market. The repo rate is quoted
at a spread to Libor (L - X).
Pledges the bond as collateral and is charged a haircut by the repo counterparty.
Each of the four trade components may not be self-explanatory to investors unfamiliar with hedging and
financing, thus these steps are expanded upon.
98
Duffie, D., Credit Swap Valuation, Financial Analysts Journal, Volume 55, no 1, Jan/Feb 1999.
99
Kasapi, A., Mastering Credit Derivatives: a step-by-step guide to credit derivatives and their application, Financial Times, London, 1999.

Interest Rate Hedge

The interest rate swap component of the trade eliminates the interest rate exposure of the cash bond (i.e. the
PV01 and the convexity). If this exposure were left unhedged the structure would simply equate to that of a
leveraged long position in the fixed rate corporate bond (T + Sc (L-X)).
Why the interest rate hedge is via a swap and not a treasury (risk-free bond) as per Duffie.
Libor is a consistent benchmark of value there are anomalies associated with pricing an asset to
a treasury given the high volatility of its term financing. As a result, Libor based benchmarking is
increasingly becoming standard. Libor is also the benchmark for the bank loan market.
Lock-in cashflows for term of the swap if the short were structured with treasuries and repo, the
financing would need to be rolled every three months, whereas when using a swap, financing is set
for the term of the structure.
Favourable economics it is cheaper to hedge with a swap that a treasury. The cost of the hedge is
net cash flow, not the cash market spread between the asset being hedged and the spread on the swap
to treasury. It may seem strange to pay the swap spread (T+ Ss) rather than the treasury coupon (T).
But the swap hedge will receive the lower treasury repo rate.
Financing of cash position
As CDS is being replicated, financing has to be introduced into the structure. This is achieved with a
corporate or sovereign bond repo. The purchase of the bond is funded via a collateralised loan to a repo
dealer. There are two important components to this trade
Haircut- charged by the lender, which is the difference between the securities purchased and money
borrowed for the loan. Haircuts vary widely according to the type of collateral, the credit of the
counterparty, the term of the repo agreement and the type of funding. It is designed to protect the
lender from market risk of the collateral. The interest earned on the haircut is compensation for
assuming the counterparty risk. Moreover since the haircut represents the capital in the trade,
institutions with the cheapest cost of capital will be able to assume the credit exposure for the lowest
net cost.
Repo Rate- the financing charge is the repo rate for the specific collateral. The rate will vary
depending on the demand to borrow (or lend) the security. This rate is denoted as L-X, since several
liquid credits have repo rates that are usually, but not always less than Libor.
Cashflows of CDS Replication

Receive Pay
Cash bond T + Sc $1
Swap hedge L T + Ss
Repo $1 (L - X)
Transaction Sc - Ss + X
Sc=Corporate spread, Ss=swap spread ( no haircut)
Closer examination of the CDS Replication table (above) reveals that the cashflow nets to (assuming a
haircut of 0% for simplicity)
(Sc Sc) X
If the repo rate of the bond were Libor flat (X=0), the exposure would be the assets swap spread (Sc Ss).
The remaining cashflow looks very much like the payment made to a protection seller of a CDS, a simple
annuity stream expressed in basis points for the life of the trade.
If the bond were to default, the repo would be terminated and the investor would lose the difference between
the purchase price and recovery price of the bond. However payments on the interest rate swap continue to
be exchanged until maturity.
The asset swap pricing approach is an efficient way to gauge CDS fair value because if the actual CDS
pricing differs significantly from that of the synthetic pricing (i.e. the asset swap), arbitrage opportunities

will emerge. Mispricing opportunities can be arbitraged most efficiently by the market makers, which have
the lowest transactions costs and institutions with the highest credit quality, which can exploit their relative
advantage in funding costs.
Any mispricing between markets (or products) has to be large enough to account for both the basis risk and
any transactions costs (slippage, brokerage). This pricing approach provides a means to assess value in the
CDS market. The table below, cashflows of a CDS spread lock demonstrate a possible arbitrage.
Cashflows of CDS Spread Lock
Receive Pay
Cash bond (Short) L - 20 L + 45
CDS 85
Net 20
The table uses the example of a five-year cash bond trading at L+45. Five-year protection for the bond is
quoted at 85/90 bps. Thus a protection seller would pay an implied repo rate of L-40, and the spread lock
would equate to 20bps of arbitrage profit. This trade assumes a term corporate bond repo market, which may
be difficult to find in most markets. The repo would most likely have to be rolled on a short-term basis,
rather than for the term of the swap.
If this arbitrage did exist, the protection sellers would eventually drive the CDS spread down toward the
asset swap level, eliminating the mispricing between the two markets. Aside from arbitrage constraints, CDS
par spreads will vary with supply and demand conditions, just like any other type of financial instruments.
Model Approach to Valuation

It can be readily argued that the best approach with which to value a CDS is via the synthetic replication as
described above. However this approach can only be utilised in cases where the reference asset, has issued
bonds that are available to trade via the secondary market.
Which introduces the modeling approach to CDS valuation, here two specific models are examined; the first
is the Hull and White model 100 and the second is the JP Morgan model 101. Both of these models (and their
modifications) are commonly used by practitioners in the market.
To convey a practical understanding of this type of valuation methodology, the JP Morgan model is
demonstrated in an easily followed example using default probabilities calculated from equation (7) and
current market data102.
Hull and White Model103

Hull and White developed a reduced form valuation model, for which their approach was to calibrate the
model based on traded bonds of the underlying reference asset on a time series of CDS prices. Like many
other approaches the Hull and White model assumes that there is no counterparty default risk. Other key
assumptions of the model include; independence of default probabilities, interest rates and recovery rates and
that the claim in the event of a default is the face value plus accrued interest.
For the valuation of a CDS with $1 nominal principal, the notation used is as follows:
T is the life of the CDS in years
q(t) is the risk-neutral probability density at time t
R is the expected recovery rate on the reference asset in a risk neutral world (independent of the time
of default)
100
Hull, J. and White, A., Valuing Credit Default Swaps I: No Counterparty Default Risk, Journal of Derivatives, 8, 1 Fall 2000.
101
2001.
102
Bloomberg L.P., SWDF, 27 Oct 2004
103
Hull, J. and White, A., Valuing Credit Default Swaps I: No Counterparty Default Risk, Journal of Derivatives, 8, 1 Fall 2000.

u(t) is the present value of payments at the rate of $1 per year on payment dates between time zero and
time t
e(t) is the present value of an accrual payment at time t equal to t - t* where t* is the payment date
immediately preceding time t (both t and t* are measured in years)
v(t) is the present value of $1 received at time t
w is the total payment per year made by the protection buyer
s is the value of w that causes the value of the CDS to have a value of zero
is the risk-neutral probability of no credit event during the life of the CDS
A(t) is the accrued interest on the reference asset at time t as a percentage of the face value
The value is one minus the probability that a credit event will occur by time T. This also known as the
survival probability and can be calculated from q(t)
T
1 q(t )dt (11)
0
The payments last until a credit event or until time T, whichever is first. If default occurs at t (t<T), the
present value of the payment is w[u(t) + e(t)]. If there is no default prior to time T, the present value of the
payment is wu(T). The expected present value of the payment is thus
w q(t ) u(t ) e(t )dt w u (t )

T
0
Given the assumption about the claim amount, the risk-neutral expected payoff from the CDS contract is
derived as follows
1 R 1 A(t ) 1 R A(t ) R
The present value of the expected payoff from the CDS is
1 R A(t )Rq(t )v(t )dt

T
0
The value of the CDS to the protection payer is the present value of the expected payoff less the present
value of the payments made by the payer
1 R A(t )Rq(t )v(t )dt w q(t ) u(t ) e(t ) dt w u(T )

T T
0 0
The CDS spread, s, is the value of w that makes the equation zero, simply rearrange the equation to be
1 R A(t ) Rq(t )v(t )dt

T
s 0 (12)
q(t ) u (t ) e(t ) dt w u (T )
T
0
The variable s is referred to as the credit default spread or CDS spread. It is the payment per annum, as a
percentage of the nominal principal, for a newly issued CDS.

JP Morgan Model104
The JP Morgan model is essentially the same as the Hull and White model. Minor distinctions between the
models are:
The JP Morgan model is a discrete form of valuation, whereas the Hull and White model is
continuous.
The JP Morgan model takes the claim amount in the event of a default as par less the recovery rate
(1-R), whereas the Hull and White model uses par less the recovery rate less any accrued interest
owed (1-R-A(t))R
All other assumptions are the same.
As stated earlier a CDS has two cashflow legs; the fee premium leg and the contingent cashflow leg. To
determine the CDS par spread (or premium of the CDS) the net present value of both legs must equal zero
(i.e. both legs have the same value).
The valuation of the fee leg is approximated by
PV of No default Fee payments = SN x AnnuityN

or
N
PV S N DFi PNDi i
i 1
where
SN is the par spread (CDS premium) for maturity N
DFi is the risk-free discount factor from time T0 to Ti
PNDi is the no-default probability from T0 to Ti (for the specific reference asset being valued)
i is the accrual period from Ti-1 to Ti
If the accrual fee for the CDS is paid upon default, then the valuation of the fee leg is approximated by
PV of No default Fee payments +PV of Default Accruals = S N x AnnuityN + SN x Default AccrualN

or
N N
i
PVNoDefault DefaultAccrual S N DFi PNDi i S N DFi PNDi 1 PNDi
i 1 i 1 2
where
(PNDi-1-PNDi) is the probability of a default occurring during period Ti-1 to Ti
i is the average accrual amount from Ti-1 to Ti
2
The valuation of the contingent leg is approximated by
PV of Contingent = ContingentN
or
N
PVContingent (1 R) DFi PNDi 1 PNDi
i 1
where
R is the recovery rate of the reference asset
104
2001.

Thus for a par CDS it is known that
Valuation of fee leg= Valuation of contingent Leg
or
N N
i N
S N DFi PNDi i S N DFi PNDi 1 PNDi (1 R) DFi PNDi 1 PNDi
i 1 i 1 2 i 1
this can be rearranged to give an equation for the CDS spread as follows
N
(1 R) DFi PNDi 1 PNDi
SN i 1
(13)
N N

i 1
DFi PNDi i S N DFi PNDi 1 PNDi i
i 1 2
Pricing Example
Consider a hypothetical CDS trade on Ford Motor Co; The CDS has a 5-year maturity with a nominal
amount of $10 million, the CDS spread is 202 bps (CDS par spreads is 213.39 bp) with payments made
semi-annually and the recovery rate is assumed to be 40% of the par value. Discount rates and survival
probabilities for each respective payment date are shown below (default probabilities are derived using
equation (7)).
CDS Valuation Example

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Term Risky Discount Survival Fixed Expected PV of Fixed Default Expected PV of Expected PV of
Curve Factors Probability Periodic Value of Fixed Payment Probability Accrued Accrued Contingent Contingent
Par Rates to Period Payment Payment (4) x (1) for the Payment Payment Payment Payment
(2) x (3) Period (3)/2 x (6) (7) x (1) (1-R) x (6) (9) x (1)
1 - (2)
(years) (%) (%) (bps) (bps) ($) (%) (bps) ($) (bps) ($)
0.0 1 100 0 0 0 0 0 0 0 0
0.5 3.0787 0.9848 99.30 106.70 105.95 104,335.18 0.6981 0.75 738.60 41.88 41,245.07
1.0 3.2874 0.9673 98.59 106.70 105.19 101,745.23 0.7168 0.78 750.36 43.01 41,599.39
1.5 3.6421 0.9466 97.48 106.70 104.00 98,450.73 1.1092 1.21 1,149.26 66.55 62,997.28
2.0 4.0031 0.9224 96.06 106.70 102.49 94,531.33 1.4182 1.58 1,452.95 85.09 78,485.49
2.5 4.3179 0.8970 94.39 106.70 100.71 90,337.77 1.6656 1.88 1,688.81 99.94 89,644.32
3.0 4.6378 0.8687 92.41 106.70 98.59 85,644.80 1.9847 2.29 1,990.54 119.08 103,439.32
3.5 4.9074 0.8400 90.29 106.70 96.33 80,914.81 2.1201 2.51 2,104.39 127.20 106,846.55
4.0 5.1756 0.8100 87.94 106.70 93.83 76,000.25 2.3491 2.85 2,308.69 140.95 114,169.62
4.5 5.4273 0.7793 85.35 106.70 91.06 70,962.30 2.5907 3.24 2,523.81 155.44 121,130.96
5.0 5.6783 0.7476 82.52 106.70 88.05 65,826.46 2.8230 3.65 2,728.60 169.38 126,628.19
Sum of PV ($) 868,748.85 Sum of PV ($) 17,435.99 Sum of PV ($) 886,186.18
Nominal Amount = $ 10,000,000, CDS Par spread = 213.39 bps (sa), Recovery Rate = 40% NPV$ 1.34
1. Valuing the Fixed Leg Fixed periodic payments
The present value of all expected fixed payments is found by multiplying each periods fixed payment by the
respective survival probability (1 minus the cumulative default probability), discounted using the discount
factor and summed over the term of the CDS. The bottom number of row (5) in the table above,
$868,748.85, is the present value of this component.
2. Valuing the Fixed Leg Accrued payments
On the basis that a credit event occurs, midway through the time interval between two payment dates, the
value of the accrued premium payment if a credit event occurs is 53.3475 bp (106.7 bp x 0.5). Then the
expected value of the accrued payment for each period in 53.3475 bp multiplied by the probability of default
for that period, as in column (7) in the above table. Discount these values for all periods and then sum them
up over the term of the CDS. The resulting present value is $17,435.99 (see the bottom of column (8)). Note
that on a relative basis this number is quite small, but this is expected, as the total is a product of the default
probability for each period and an accrued payment, should a credit event occur - both of which are small
numbers.
Taking these two component values above and adding them together provides the present value of the fixed
leg (or the PV of the expected payments by the protection buyer over the full 5-year term), which is
$868,748.85 + $17,435.99 = $886,184.84.
3. Valuing the Contingent Leg
Finally the contingent leg can be calculated. The expected value of the contingent payment in the case of a
credit event occurring in each period is (1-R) multiplied by the default probability for that period (column (9)
in the table). Taking a recovery rate of 40%, the expected contingent payment is 0.60 multiplied by each
periods default probability. Discount this value for each period and then sum them over the term of the CDS
contract. The resulting value is $886,186.13 as in column (10), which is the present value of the expected
contingent payments.
From here the value of the CDS to the protection buyer (or the fixed payer) when the CDS spread is 213.39
bp per annum as:
Value of CDS = PV [contingent leg] PV [fixed leg] = $886,186.13 - $886,184.84 =$1.34
To view this result intuitively, the average default probability of the term of the CDS is 3.5% per annum (as
the survival rate after 5-years is 82.52%) and with a recovery rate of 40%, the average expected loss per year
is (1 - 0.40) x 3.5% = 2.1%. The CDS spread is 213.39bp per annum, meaning that in this example the buyer
has protection for credit risk with the expected loss of 210 105 bps (on Ford).
105
Actually the Par CDS spread is 213.390323 bp (i.e. when the CDS NPV is zero).

Bibliography
Books
JP Morgan., The J.P. Morgan Guide to Credit Derivatives; Risk Publications, London, 1999.
Kasapi, A., Mastering Credit Derivatives: a step-by-step guide to credit derivatives and their application,
Financial Times, London, 1999.
Steiner, R., Mastering Financial Calculations: A step-by-step guide to the mathematics of financial market
instruments, Financial Times, London, 1999.
Wilmott, P., Paul Wilmott on Quantitative Finance-Volume One, John Wiley & Sons, London, 2000.
Wilmott, P., Paul Wilmott on Quantitative Finance-Volume Two, John Wiley & Sons, London, 2000.
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balancesheet items, April 1995.
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Standards, Basle, July 1988.
Basle Committee on Banking Supervision, Consultative Document: Overview of the New Basel Capital
Accord, Basle, Apr 2003.
Berndt, O and Veras de Melo, B., Capital Structure Arbitrage Strategies: Models, Practice and Empirical
Evidence, Master Thesis, HEC, Lausanne, Switzerland, Nov 2003.
Black, F. and Scholes, M., The Pricing of Options and Corporate Liabilities; Journal of Political Economy,
Vol. 81, pgs 81-98, 1973.
Capital Markets Quantitative Research., Portfolio Credit Derivatives Insights A framework for managing
tranche and Nth to default transactions, The Royal Bank of Scotland, London, 2004.
Choudhry, M., Fourth-Generation CDO Structures: Credit Trading via the Managed CDO, Bloomberg
Seminar, Jul 2002.
Delianeis, G. and Geske, R., The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps,
Liquidity and Market Factors, University of California, Los Angeles, 2001.
Duffie, D., Credit Swap Valuation, Financial Analysts Journal, Volume 55, no 1, Jan/Feb 1999.

Duffee, G. and Zhou, Chunsheng., Credit Derivatives in Banking: Useful Tools for Loan Risk
Management?; Federal Reserve Board, Washington DC, Feb 1997.
Finance and economics editor. Credit derivatives: Russian doll, The Economist, Volume 372, Number 8394,
25 September 2004.
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2002.
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Henry, D., Fuzzy Numbers, Business Week, European Edition, Number 3886-1216, October 4 2004.
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University of Toronto, Feb 25, 2003.
Hull, J. Predescu, M, and White, A., The Relationship Between Credit Default Swap Spreads, Bond Yields
and Credit Rating Announcements; Working Paper, University of Toronto, Mar 2003.
Hull, J. and White, A., Valuing Credit Default Swaps I: No Counterparty Default Risk, Journal of
Derivatives, 8, 1 Fall 2000.
Hull, J. and White, A., Valuing Credit Default Swaps II: Modeling Default Correlations; Journal of
Derivatives, 8, 3 Spring 2001.
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Credit Derivatives An Introduction To The Products

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Credit Derivatives An Introduction To The Products

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Credit Derivatives: An introduction to the products,

applications, participants and pricing.

Michael Duncan (31384161)

Supervising Professor: Rae Weston

MGSM 952, Research Project, November 2004, London Page 2

MGSM 952, Research Project, November 2004, London Page 3

Introducing Credit Risk1

What is Credit Risk?

Credit Default Risk

MGSM 952, Research Project, November 2004, London Page 4

Credit Rating Migration

Major Risk Categories

MGSM 952, Research Project, November 2004, London Page 5

MGSM 952, Research Project, November 2004, London Page 6

Sources of Credit Risk Exposure

MGSM 952, Research Project, November 2004, London Page 7

Average One-Year Transition Rates (1981-2003)

Cumulative Average Default Rates (1981-2003) %

MGSM 952, Research Project, November 2004, London Page 8

MGSM 952, Research Project, November 2004, London Page 9

The Term Structure of Credit Spreads

MGSM 952, Research Project, November 2004, London Page 10

MGSM 952, Research Project, November 2004, London Page 11

Economical Rationale for Managing Credit Risk

MGSM 952, Research Project, November 2004, London Page 12

MGSM 952, Research Project, November 2004, London Page 13

Credit Derivative Products

Classification of Credit Derivatives

Credit Event Instruments

Instruments within this class are:

MGSM 952, Research Project, November 2004, London Page 14

Credit Default Swaps (CDS)

P r o te c tio n B u y e r P r o te c tio n S e lle r

Basket Default Swaps27

MGSM 952, Research Project, November 2004, London Page 15

P r o te c tio n B u y e r P r o te c tio n S e lle r

MGSM 952, Research Project, November 2004, London Page 16

Credit Linked Notes

Collateralised Debt Obligations33

MGSM 952, Research Project, November 2004, London Page 17

MGSM 952, Research Project, November 2004, London Page 18

Balance Sheet vs. Arbitrage CDO 35

Cash vs. Synthetic CDO

Synthetic CDO Structure

Portfolio CDS Cash

MGSM 952, Research Project, November 2004, London Page 19

For arbitrage synthetic CDO, two advantages are

Static vs. Managed CDO39

Cashflow vs. Market Value CDO

MGSM 952, Research Project, November 2004, London Page 20

Credit Spread Instruments 41

Instruments within this class include:

Credit Spread Forwards

MGSM 952, Research Project, November 2004, London Page 21

Credit spread options

Credit Spread Option

Credit Spread Options - Payoffs

Long Put Long Call

MGSM 952, Research Project, November 2004, London Page 22

Total Return Instruments

Key features of a total return instrument are:

Total Return Swap: (total rate of return swap) 43

Total Rate of Return Swap

100e y (T ) 1 Q(T )100e y(T )T Q(T )100Re y(T )T