Credit derivatives: trading, investing and risk management

Preface to the First Edition xvii  Preface to the Second Edition xix  Acknowledgements xxi  Disclaimer xxiii  Table of Spreadsheet Examples and Software xxvii  About the Author xxix   PART I CREDIT BACKGROUND AND CREDIT DERIVATIVES 1    1 Credit Debt and Other Traditional Credit Instruments 3   1.1 Bonds and Loans
 Libor Rates and Swaps
 'REPO' and General Collateral Rates 3  1.2 Credit Debt Versus 'Risk-Free' Debt 6  1.3 Issue Documents, Seniority and the Recovery Process 6  1.4 Valuation, Yield and Spread 10  1.5 Buying Risk 10  1.6 Marking to Market, Marking to Model and Reserves 11  1.7 The 'Credit Crunch' and Correlation 12  1.8 Parties Involved in the Credit Markets and Key Terminology 13   2 Default and Recovery Data
 Transition Matrices
 Historical Pricing 15   2.1 Recovery: Ultimate and Market-Value-Based Recovery 15  2.2 Default Rates: Rating and Other Factors 21  2.3 Transition Matrices 21  2.4 'Measures' and Transition Matrix-Based Pricing 22  2.5 Spread Jumps and Spread Volatility Derived from Transition Matrices 26  2.6 Adjusting Transition Matrices 27   3 Asset Swaps and Asset Swap Spread
 z-Spread 29   3.1 'Par-Par' Asset Swap Contracts 29  3.2 Asset Swap Spread 30  3.3 Maturity and z-Spread 30  3.4 Callable Asset Swaps
 'Perfect' Asset Swaps 32  3.5 A Bond Spread Model 33   4 Liquidity, the Credit Pyramid and Market Data 35   4.1 Bond Liquidity 35  4.2 The Credit Pyramid 35  4.3 Engineered and Survey Data 37  4.4 Spread and Rating 39   5 Traditional Counterparty Risk Management 41   5.1 Vetting 41  5.2 Collateralisation and Netting 41  5.3 Additional Counterparty Requirements for Credit Derivative Counterparties 42  5.4 Internal Capital Charge 42   6 Credit Portfolios and Portfolio Risk 43   6.1 VaR and counterpartyVaR 43  6.2 Distribution of Forward Values of a Credit Bond 43  6.3 Correlation and the Multi-Factor Normal (Gaussian) Distribution 45  6.4 Correlation and the Correlation Matrix 46   7 Introduction to Credit Derivatives 49   7.1 Products and Users 49  7.2 Market Participants and Market Growth 51   PART II CREDIT DEFAULT SWAPS AND OTHER SINGLE NAME PRODUCTS 55    8 Credit Default Swaps
 Product Description and Simple Applications 57   8.1 CDS Product Definition 57  8.2 Documentation 60  8.3 Credit Triggers for Credit Derivatives 65  8.4 CDS Applications and Elementary Strategies 67  8.5 Counterparty Risk: PFE for CDS 71  8.6 CDS Trading Desk 71  8.7 CDS Contract and Convention Changes 2009 73   9 Valuation and Risk: Basic Concepts and the Default and Recovery Model 81   9.1 The Fundamental Credit Arbitrage -- Repo Cost 81  9.2 Default and Recovery Model
 Claim Amount 82  9.3 Deterministic Default Rate Model 87  9.4 Stochastic Default Rate Model
 Hazard and Pseudo-Hazard Rates 94  9.5 Calibration to Market Data 97  9.6 CDS Data/Sources 102  9.7 Model Errors and Tests 105  9.8 CDS Risk Factors
 Reserves and Model Risk 108   10 CDS Deal Examples 113   10.1 A CDS Hedged Against Another CDS 113  10.2 Introduction to Bond Hedging 124  10.3 Hedge and Credit Event Examples 126   11 CDS/Bond Basis Trading 131   11.1 Bond Versus CDS: Liquidity 131  11.2 Bond Repo Cost 132  11.3 Bond Spread Measurement -- z-Spread not Asset Swap Spread 133  11.4 Bond Price Impact 133  11.5 Embedded Options in Bonds and Loans 134  11.6 Delivery Option in CDSs 135  11.7 Payoff of Par 136  11.8 Trigger Event Differences 136  11.9 Embedded Repo Option 137  11.10 Putting it All Together 138   12 Forward CDS
 Back-to-Back CDS, Mark to Market and CDS Unwind 139   12.1 Forward CDS 139  12.2 Mark-to-Market and Back-to-Back CDS 140  12.3 Unwind Calculation
 Off-Market Trade Valuation and Hedging 141  12.4 'Double-Trigger CDS' 142   13 Credit-Linked Notes 145   13.1 CLN Set-Up
 Counterparty or Collateral Risk 145  13.2 Embedded Swaps and Options 147  13.3 Costs 148  13.4 Applications 148  13.5 CLN Pricing 149  13.6 Capital Guaranteed Note 150   14 Digital or 'Fixed Recovery' CDS 155   14.1 Product Description 155  14.2 Pricing, Hedging, Valuation and Risk Calculations 155  14.3 Trigger Event Differences 157   15 Spread Options, Callable/Puttable Bonds, Callable Asset Swaps, Callable Default Swaps 159   15.1 Product Definitions 159  15.2 Model Alternatives and a Stochastic Default Rate Model for Spread Option Pricing 162  15.3 Sensitivities and Hedging 164   16 Total Return Swaps 167   16.1 Product Definition and Examples 167  16.2 Applications 167  16.3 Hedging and Valuation 168   17 Single Name Book Management 171   17.1 Risk Aggregation 171  17.2 CreditVaR for CDSs 173   18 CDS and Simulation 175   18.1 The Poisson Model and Default Times 175  18.2 Valuation by Monte Carlo Simulation 175  18.3 Sensitivity 178   PART III PORTFOLIO PRODUCTS 181    19 Portfolio Product Types 183   19.1 Nth-to-Default Baskets 184  19.2 'Synthetic' CDOs 188  19.3 Cashflow CDOs 210  19.4 Credit Securitisations 220  19.5 Rating 222  19.6 Alternative Levered Credit Portfolio Products 222   20 The Normal Copula and Correlation 227   20.1 Default Time Correlation 227  20.2 Normal Copula 236  20.3 Correlation 244   21 Correlation in Practice 253   21.1 Tranche Correlation 253  21.2 Base Correlation 257  21.3 Correlated Recoveries 261  21.4 Correlation Regime Change and Other Modelling Approaches 262   22 Valuation and Hedging 265   22.1 Valuation Examples 265  22.2 Sensitivity Calculation and Hedging 270  22.3 Pricing More Complex Structures 282  22.4 Model Errors and Tests
 Alternative Models 284   23 Alternative Copulas 289   23.1 Student's t-Distribution 289  23.2 Copulas in General 290  23.3 Archimedean Copulas: Clayton, Gumbel 291  23.4 Clayton at theta = 0 and theta = infinity 293  23.5 Model Risk 293   24 Correlation Portfolio Management 297   24.1 Static and Dynamic Hedges 297  24.2 Correlation Book Management 298  24.3 CreditVaR and CounterpartyVaR 300  PART IV DEFAULT SWAPS INCLUDING COUNTERPARTY RISK 303   25 Single Name CDS 303   25.1 Non-Correlated Counterparty 305  25.2 100% Correlation 306  25.3 Correlated Counterparty: Pricing and Hedging 308  25.4 Choice of Copula 309  25.5 Collateralised Deals and CDS Book Management 309   26 Counterparty CDSs 313   26.1 Pricing 313  26.2 Counterparty CDS (CCDS) Book Management 313   PART V SYSTEMS IMPLEMENTATION AND TESTING 317    27 Mathematical Model and Systems Validation 319   27.1 Testing Procedures 319  27.2 Implementation and Documentation 321   28 System Implementation 323   28.1 Anatomy of a CDO 323  28.2 Management 325  28.3 Valuation 329  28.4 IT Considerations 331   PART VI THE CREDIT CRISIS 335    29 Cause and Effect: Credit Derivatives and the Crisis of 2007 337   29.1 The Credit Markets Pre-Crisis 337  29.2 The Events of MID-2007 341  29.3 Issues to be Addressed 346  29.4 Market Clearing Mechanisms 350  Appendix Markit Credit and Loan Indices 355  References 363  Index 365