Foreword ix
Introduction xi
1 Credit Risk and the Emergence of Credit Derivatives 1
1.1 Credit Risk 1
1.1.1 Definition and Typology of Credit Risk 3
1.1.2 Characteristics of Credit Risk 4
1.1.3 The Importance of Credit Risk in Capital Markets 8
1.2 Assessment and Measurements of Credit Risk 11
1.2.1 Bank Capital Adequacy Standards (Basel I) 11
1.2.2 Credit Risk Analyzed by Rating Agencies 14
1.2.3 Credit Risk Measured in the Financial Markets: Credit Spread 20
1.3 Traditional Methods of Credit Risk Management and the Emergence of
Credit Derivatives 24
1.3.1 Traditional Methods for Managing Credit Risk (Issuer Risk) 25
1.3.2 Counterparty Risk Management in Derivatives Markets 27
1.3.3 Emergence and Advantages of Credit Derivatives 29
2 Typology of Credit Derivatives and their Main Applications 35
2.1 Credit Default Swaps 35
2.1.1 Description of Credit Default Swaps 36
2.1.2 Comparison Between the CDS Market and the Cash Market: Basis 45
2.1.3 Main Variations on CDSs 49
2.2 Other Credit Derivatives 55
2.2.1 Credit Spread Derivatives 55
2.2.2 Synthetic Replication Products 61
2.3 Main applications of Credit Derivatives 66
2.3.1 Applications for Institutional Investors and Other Capital
Market players 66
2.3.2 Credit Derivative Applications in Bank Management 70
2.3.3 Credit Derivative Applications for Corporates 74
vi Contents
3 Second-Generation Credit Derivatives 81
3.1 Basket Credit Default Swaps 81
3.1.1 First-to-Default Credit Swaps 82
3.1.2 Concrete Example 87
3.1.3 Extension of the First-to-Default Principle: i to j-to-Default
Products 89
3.2 Hybrid Products 90
3.2.1 Capital-Guaranteed/Protected Products 90
3.2.2 Other Hybrid Products 92
3.2.3 Concrete Example of a Transaction 93
3.3 Credit Indices 94
3.3.1 Introduction to Credit Indices 94
3.3.2 Credit Index Mechanism, Pricing and Construction 96
3.3.3 iTraxx Indices: a True Innovation to Benefit Investors 101
4 Collateralized Debt Obligations 105
4.1 Cash-Flow CDOs (Arbitrage CBOs and CLOs) 107
4.1.1 Origin of Arbitrage CBOs/CLOs 107
4.1.2 Description of a CDO Structure 109
4.1.3 Overview of the CBO/CLO Market and Recent Developments 113
4.2 Balance Sheet-Driven CDOs 114
4.2.1 Securitization of Bank Loans 114
4.2.2 The Impact of Credit Derivatives: Synthetic CLOs 115
4.2.3 Balance Sheet-Driven CDOs and Regulatory Arbitrage 119
4.3 Arbitrage-Driven Synthetic CDOs 124
4.3.1 The First Arbitrage-Driven Synthetic CDOs 124
4.3.2 Actively Managed Arbitrage-Driven Synthetic CDOs 128
4.3.3 On-Demand CDOs (Correlation Products) 133
5 The Credit Derivatives and Structured Credit Products Market 149
5.1 Overview of the Market 150
5.1.1 Main Stages in the Development of the Credit Derivatives Market 151
5.1.2 Size, Growth and Structure of the Credit Derivatives Market 152
5.1.3 Size, Growth and Structure of the CDO Market 159
5.2 Main Players 160
5.2.1 Banks 161
5.2.2 Insurance, Reinsurance Companies and Financial Guarantors 163
5.2.3 Hedge Funds and Traditional Asset Managers 165
5.2.4 Corporates 167
5.3 At the Heart of the Market: The Investment Banks 168
5.3.1 Position of the Investment Banks in the Credit Derivatives Market 168
5.3.2 Position of the Investment Banks in the CDO Market 170
5.3.3 Functions and Organization of Investment Banks 172
6 Pricing Models for Credit Derivatives 175
6.1 Structural Models 176
6.1.1 The Black–Scholes Option Pricing Model 176
Contents vii
6.1.2 Merton’s Structural Model of Default Risk (1976) 178
6.1.3 Limitations and Extensions of the Merton Model (1976) 180
6.1.4 Pricing and Hedging Credit Derivatives in Structural Models 183
6.2 Reduced-Form Models 184
6.2.1 Hazard Rate and Credit Spreads 184
6.2.2 Pricing and Hedging of Credit Derivatives in Reduced-Form Models 187
6.2.3 Accounting for the Volatility of Credit Spreads 188
6.2.4 Accounting for Interest Rate Risk 189
6.3 Pricing Models for Multi-Name Credit Derivatives 189
6.3.1 Correlation, Dependence and Copulas 190
6.3.2 The Gaussian Copula Model 191
6.3.3 Multi-Asset Structural Models 195
6.3.4 Dependent Defaults in Reduced-Form Models 195
6.4 Discussion 196
6.4.1 Comparing Structural and Reduced-Form Modeling Approaches 196
6.4.2 Complex Models, Sparse Data Sets 197
6.4.3 Stand-alone Pricing Versus Marginal Pricing 198
7 The Impact of the Development in Credit Derivatives 199
7.1 The Impact of the Growth in Credit Derivatives on Banking Institutions 200
7.1.1 Far-Reaching Changes in the Capital Markets 200
7.1.2 An Economic Approach to Credit Risk Management 204
7.1.3 Overview of the Banks of the Twenty-First Century: the Effect of
Credit Derivatives on Banks’ Strategy, Organization and Culture 217
7.2 Credit Derivatives and Financial Regulations 223
7.2.1 Credit Derivatives and the New Basel II Regulations 223
7.2.2 Credit Derivatives and the Instability of the Financial System 234
7.2.3 A More Rounded Picture 237
7.3 Credit Derivatives: A Financial Revolution? 241
7.3.1 Introduction to Particle Finance Theory 242
7.3.2 Implications of ‘Particle Finance Theory’ for the Capital Markets 243
7.3.3 An Innovation that Heralds Others 247
Conclusion 251
References 255
Further Reading 259
Index 263