If you are looking
for the definitive book on credit derivatives pricing, look no further.
Schönbucher's has written a masterpiece. Not only is it comprehensive, but the
writing is superb. The book is simultaneously informative and a pleasure to
read!
Schönbucher opens with a well crafted introduction to
standard credit derivatives. This leads into basic arbitrage conditions that
place bounds on credit derivative prices as well as a crude indication of
reasonable prices. These opening discussion are not hurried, taking time to
explain things such as differences between corporate and sovereign credits (the
latter can selectively default on obligations.)
In Chapter 3, the book introduces a simple
framework for pricing credit derivatives that anticipates more sophisticated
refinements in subsequent chapters. Schönbucher explains how spread curves can be calibrated
to traded instruments such as coupon bonds or credit default swaps (CDS). The
added complexity of recovery modeling is mentioned but mostly left for later
development.
Up until this point, the book is not overly
technical, with Chapter 4, it starts to read like a serious financial
engineering text. The accessible writing style remains, but the
technical level takes a noticeable step up. Assuming familiarity with basic
stochastic calculus, including such notions as measurability, martingales,
filtrations, and stochastic integrals, Chapter 4 delves into the non-continuous
stochastic calculus of point and jump processes.
With the mathematics of Chapter 4 in hand, Chapters
5, 6, and 7 largely complete the modeling task initiated in Chapter 3. They
detail how to implement deterministic and stochastic intensity models of default.
They also describe several alternative models for recovery. Stochastic intensity is modeled
with either a Gaussian or CIR process. These facilitate closed form pricing for
simple credit derivatives. Other instruments require numerical solutions (trees,
the Monte Carlo method, etc.) which are discussed in some detail.
Chapter 8 shifts gears and considers ratings
migration models. It covers issues of generating transition matrices,
calibration and integrating the models with the intensity models described in
previous chapters.
Chapter 9 introduces structural default models
based upon the original Merton model.
Contents
1. Introduction.
2. Credit Derivatives: Overview and
Hedge-Based Pricing.
3. Credit Spreads and Bond Price-Based
Pricing.
4. Mathematical Background.
5. Advanced Credit Spread Models.
6. Recovery Modelling.
7. Implementation of Intensity-Based
Models.
8. Credit Rating Models.
9. Firm Value and Share Price-Based
Models.
10. Models for Default Correlation.
Chapter 10 covers default correlation models.
Factor models integrate well with structural default models, making them an
attractive choice for pricing multiple obligor instruments. Several models for
extending intensity models to multiple obligors are discussed, but not with so
much success. The chapter closes with a discussion of copula models.
Prior knowledge of copulas, as covered by Nelsen (1999),
will be helpful.
Strengths of this book are its broad coverage of
topics, sophistication, and excellent writing. Modest
criticisms are that the notation, while used consistently, tends to be
cumbersome. Just one example is a symbol that appears on p. 64. It represents
the maturity of a security. It has a subscript. The subscript has both a
superscript and a subscript. That sub-subscript has a superscript. Ouch!!! The
book could also do with more examples.
Two supplementary texts that I recommend are Duffie
and Singleton (2003) and Bluhm
et al (2002). Both are more
elementary than Schönbucher. They cover similar ground, with Duffie and
Singleton (2003) emphasizing
intensity models, and Bluhm et al (2002)
emphasizing structural models. See also Gregory's (2003) edited volume on
credit derivatives. While only some of its chapters focus on pricing, it offers
a practitioner-oriented balance to the theoretical focus of Schönbucher. For
credit derivatives financial engineering, none of these books can replace Schönbucher;
it is the gold standard.
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