ABSTRACT
This chapter starts with default probabilities and investigates how to derive risk-neutral default probabilities from bond prices and asset swap rates using the spreadsheet approach. The chapter explains the management of credit risk, in particular default risk, by introducing single-named credit derivatives – credit default swaps (CDSs) – and describing CDS valuation using the spreadsheet and simulation methods. Multiple-named credit derivatives (collateralized debt obligations or CDOs) are introduced. CDOs are often modeled with the copula method, which has been used effectively (and ineffectively!) to capture the tendency of actual default rates to differ randomly from expected default rates. An important problem in applications of the copula method (which was not adequately noted before the global financial crisis) is that CDO values are very sensitive to copula correlations and recovery rates. As learned from the global financial crisis, correct modeling of the copula correlation and recovery rates is vital for accurate value and risk estimation. Sample spreadsheets for extracting default probabilities from bonds, asset swaps and CDSs are offered. Sample R-codes for valuing a CDS, as well as an algorithm for valuing CDOs, are offered. A project of calibrating the survival curve from market CDS quotes is provided.
