ABSTRACT
In this chapter we introduce credit markets and default risk. We begin by developing the most common type of default model, a hazard rate model. We then discuss modeling of bonds and Credit Default Swaps. Additionally, we highlight the fundamental differences between bonds and CDS and discuss why a basis between the two emerges. We then show how to extract hazard rates from a set of traded bond prices of CDS spreads as we did in the previous chapter for a yield curve. Next, we introduce CDS on a credit index instead of a single-name credit and describe how they can be valued. We then cover non-linear instruments, including options on CDS & indices, and Collateralized Debt Obligations. Next, we explore the connection between credit and equity markets in the form of Merton models. Finally, we conclude by considering an investment perspective highlighting several traded structures of interest.
