Lecture20 - 11/16/2010 MGMT 4370 / MGMT 7760 Risk...

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11/16/2010 1 MGMT 4370 / MGMT 7760 Risk Management Aparna Gupta Lally School of Management and Technology Office: PITTS 2104 Email: guptaa@rpi.edu Phone: x2757 Credit Derivatives and Securitization 2 Aparna Gupta, Lally School, RPI Credit Derivatives – Credit Default Swap (CDS) Credit derivatives are mostly structured or embedded in swaps, options. They are normally of a shorter maturity than the underlying loans/bonds. Credit default swaps are the most popular – making 73% of the credit derivatives market. CDS can be thought of as an insurance against default of some underlying instrument or as a put option on the underlying instrument. A credit default swap may specify that a payment be made if a 10- year corporate bond defaults at any time in the next 2 years. 3 Aparna Gupta, Lally School, RPI Credit Derivatives – Credit Default Swap (CDS) The protection buyer (or seller of credit risk) makes periodic premium payments to the protection seller of a negotiated basis points times the notional amount of the underlying bond or loan. The party buying the credit risk makes no payment unless the issuer of the underlying bond or loan defaults. In the event of a default, the protection seller pays the protection buyer a default payment equal to the notional amount minus pre- specified recovery factor. The recovery factor captures what the bank may recover of the notional value after default from collateral, etc. Important : the default should be clearly defined in the contract. – There is often a materiality clause requiring the change in credit status be validated by third-party evidence. 4 Aparna Gupta, Lally School, RPI Credit Derivatives – First-to-Default Swap These Swaps are on a portfolio. The protection buyer pays premium up to the first default. At the event of first default alone the protection seller pays the loss
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Lecture20 - 11/16/2010 MGMT 4370 / MGMT 7760 Risk...

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