Credit Default Swaps, CDOs, and
The market for credit derivatives is seeing rapid growth. According to a 2002 survey by the British Bankers’Association (BBA), the estimated size of the market by the end of 2002 was set at almost $2 trillion and the BBA expects the size of the market to reach $5 trillion by the end of 2004.
In this chapter we present the most important vehicles for transferring credit risk, namely variations of the default swaps and a class of asset-backed securities broadly referred to as Collateralized Debt Obligations (CDOs). In the BBA survey, so-called single-name default swaps accounted for almost half of the market volume in credit derivatives and almost a quarter of the volume was in “portfolio products/Collateralized Loan Obligations (CLOs).” This chapter will look at these most important classes of credit derivatives. The main purpose is to understand the fundamental structure of these instruments and how they interact.
We will also consider a few basic issues in building pricing models, but one should be aware that this area—as with corporate bonds in general—is rich in institutional detail. Hence the models tend to deal with stylized versions. As always, one hopes that the stylized structures overcome enough of the most important obstacles in modeling to make it relatively straightforward to build on the basic structures to accommodate particular institutional features. We will not derive more than a few analytical formulas. For multi-name contracts one usually ends up having to simulate the models anyway. We focus therefore on some basic calculations which are helpful for the simulations. Once simulations are called for, the worry then becomes what kind of correlation structure to impose, and this is the topic of the next chapter.
The market for credit risk transfer is rich with institutional details and we will not attempt to go into a lot of detail here. Rather, this section serves as an introduction to the most important structures and hints at their definitions and uses.