ABSTRACT
In the years before 2008, investors of credit markets had witnessed a rapid growth of liquidity in credit default swaps (CDS), options on the credit default swaps, tranches of collateralized debt obligations (CDO), as well as exotic portfolio of credit derivatives like bespoke single-tranche CDOs and CDOs of CDOs. This chapter addresses the pricing of CDS, and demonstrate that the model for CDS can be used for pricing CDO as well, with the adoption of copula, an additional mathematical tool, through the so-call bottom-up strategy. For the pricing of single-name credit derivatives, the new model is highly analogous to the LIBOR market model. In a very natural way, such a model can be applied to pricing CDO tranches using Monte Carlo simulations. The Gaussian copula model can take the default probabilities estimated from the CDS markets as inputs, it has no capacity to utilize either spread dynamics or spread correlations observed in the CDS markets for CDO pricing.
