Credit Derivatives
The Definitive Guide

Credit Derivatives: The Definitive Guide is precisely what its name suggests. It is an edited collection of 21 chapters on all aspects of credit derivatives. Its depth of detail will command the attention of even experienced sell-side professionals.

 

Chapters are divided into five sections:

The default swap market

Default correlation and credit portfolio risk

Structured credit derivatives and portfolio management

Models and valuation

Regulatory, documentation and legal aspects

Chapters of the first section discuss many aspects of the credit default swap (CDS) market. One topic that receives focused attention is drivers of the CDS basis. To avoid arbitrage opportunities, one might think CDS spreads should equal corresponding cash market credit spreads—but they often don't. The difference is called the credit swap basis. Two chapters delve into what drives this basis and describe the credit swap "smile" that has the basis being high for the best and worst credits and low for average credits. Another chapter delves into different types of default events and discusses industry responses to the challenges posed by "soft" defaults due to restructurings. The final chapter of the section introduces the Merton ("structural") models of credit risk.

The second section is the least satisfying. It has only three chapters. The first is a surprisingly elementary discussion of nth to default swaps. The second is a succinct (and the best that I am aware of) comparison of industry standard portfolio credit risk models—KMV, CreditMetrics, etc. Assuming familiarity with much of the theory of portfolio credit risk modeling, it compares how each of the standard models applies that theory. The third chapter discusses credit portfolio optimization—think "credit risk meets efficient frontiers."

The third section offers an in-depth look at the collateralized debt obligation (CDO) market that actually extends into the fist chapter of the next section. All together, this book devotes almost 200 of its 485 pages to CDOs. The material could form a stand-along book on CDOs—and an outstanding book at that. There is some overlap among chapters, but having different perspectives on the same material is useful.

Contents

The default swap market

1. Credit derivatives: the past, the present and the future

2. The determinant of credit spread returns

3. What's driving the default swap basis?

4. What is the value of modified restructuring?

5. The debt and equity linkage and the valuation of credit derivatives

Default correlation and credit portfolio risk

6. Nth to default swaps and notes: all about default correlation

7. Portfolio credit risk models

8. Credit derivatives as an efficient way of transitioning to optimal portfolios

Structured credit derivatives and portfolio management

9. Overview of the CDO market

10. Synthetic securitization and structured credit derivatives

11. Structured credit and the collateralized synthetic obligation

12. Distinguishing a synthetic CDO from a cash CDO

13. CDOs of CDOs

Models and valuation

14. Valuation and risk analysis of synthetic CDOs: A copula function approach

15. Extreme events and multi-name credit derivatives

16. Reduced-form models: curve construction and the pricing of credit swaps, options, and hybrids

17. Dynamite dynamics

18. Modelling and hedging of default risk

Regulatory, documentation and legal aspects

19. ISDA's role in the credit derivatives marketplace

20. Credit linked notes

21. Using guarantees and credit derivatives to reduce credit risk capital requirements under the new Basel Capital Accord

Section Four looks at pricing methodologies. Assuming basic knowledge of credit risk pricing, its chapters delve into cutting-edge theory for valuing credit derivatives or CDOs. Discussions are sophisticated and applications oriented, which makes them excellent follow-up reading after Schönbucher's (2003) more theoretical bible on credit derivatives pricing. Prior knowledge of copulas, as covered by Nelsen (1999), will be helpful. The chapters will appeal primarily to financial engineers and researchers. Numerous references to the literature are very helpful. Less technically-inclined readers may skim the material or skip it entirely.

A brief final section has a chapter on ISDA documentation, another on credit-linked notes, and a third on Basle II.

Despite some minor criticisms, this is an exceptional book on credit derivatives—easily the most authoritative one available. Chapters are not integrated, but they are very sophisticated and offer broad coverage of the topic.

While I describe the book as being of average technical difficulty, that is very much an average. Much of the book is non-technical. The discussions of financial engineering in Section Four are highly technical. Material on CDS and CDOs is extensive and superb. More material on nth to default swaps would be nice. One topic that is not discussed is total return swaps. Perhaps this reflects an (entirely defensible) view that these aren't true credit derivatives.

For sophisticated practitioners, this is THE book to read on credit derivatives. I also highly recommend it as an excellent resource on CDOs.
 

 

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