ABSTRACT
Credit derivatives are instruments that help banks, financial institutions, and debt security investors to manage their credit-sensitive investments. Credit derivatives insure and protect against adverse movements in the credit quality of the counterparty or borrower. For example, if a borrower defaults, the investor will suffer losses on the investment, but the losses can be offset by gains from the credit derivative transaction. One might ask why both banks and investors do not utilize the well-established insurance market for their protection. The major reasons are that credit derivatives offer lower transaction cost, quicker payment, and more liquidity. Credit default swaps, for instance, often pay out very soon after the event of default1; in contrast, insurances take much longer to pay out, and the value of the protection bought may be hard to determine. Finally, as with most financial derivatives initially invented for hedging, credit derivatives can now be traded speculatively. Like other over-the-counter derivative securities, credit derivatives are privately negotiated financial contracts. These contracts expose the user to operational, counterparty, liquidity, and legal risk. From the viewpoint of quantitative modeling we here are only concerned with counterparty risk. One can think of credit derivatives being placed somewhere between traditional credit insurance products and financial derivatives. Each of these areas has its own valuation methodology, but neither is wholly satisfactory for pricing credit derivatives. The insurance techniques make use of historical data, as, e.g., provided by rating agencies, as a basis for valuation (see Chapter 6).
