LectureNotes02PF

LectureNotes02PF - IEOR E4731: Credit Risk and Credit...

Info iconThis preview shows pages 1–6. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: IEOR E4731: Credit Risk and Credit Derivatives Lecture 02: Market for credit risk Notes originally written by Prof. Rama Cont Instructor: Xuedong He Spring, 2012 1 / 28 Credit derivatives I Derivative instruments with payoffs linked to the occurrence of a credit event I Developed in the mid 1990s and evolved rapidly with the occurrence of many large defaults: Russian debt crisis 1998, WorldCom, Enron,... I Underlying default risks: sovereign debt (countries), corporate debt (bonds and loans), personal loans (car loans, mortgages, credit cards,..) I Linked to the widespread securitization of credit. 2 / 28 Credit default swap I Credit default swap (CDS) is the most common credit derivative I A default swap is a bilateral contract that allows an investor to buy protection against the risk of default of a specified reference credit. I Following a (pre-specified) credit event (default of reference entity or lack of payment of coupon), the protection buyer receives a payment usually intended to compensate him/her for the loss made on this credit event. I In return the protection buyer pays a fee to the protection seller. I In return the protection buyer pays a fee to the protection seller. This fee is often paid over the life of the transaction in the form of a periodic cashflow, defined as a spread in to the protection seller. I This spread is paid typically quarterly until default occurs. I The spread is set so that the value of the CDS is zero at inception and remains fixed during the life of the CDS 3 / 28 Settlement I Protection buyer shorts credit risk, and protection seller longs credit risk. I If default occurs, two forms of settlement: I Physical settlement: at default (or a at fixed delay after default is announced) protection buyer gives defaulted bond to protection seller, who buys it back at par (nominal) value. I Cash settlement: at default (or a at fixed delay after default is announced) protection buyer received nominal x (1- Recovery rate on defaulted obligor) I Important point: protection buyer need not possess the defaultable instrument in the first place. 4 / 28 Why trade credit default swaps? I Buying protection through a default swap to hedge the risk of default. I Synthetic alternative to selling the reference credit if investors not allowed to short sell an asset but allowed to buy a credit derivative. I Shorting a credit via a default swap is a private transaction between two counterparties whereas short selling of a loan may require customer consent. I Investors can tailor maturity and seniority of CDS to match their precise requirements. I Banks with high funding costs may find it cheaper to buy exposure to the credit via a default swap rather than buy the cash bond and fund it on balance sheet....
View Full Document

This note was uploaded on 03/14/2012 for the course IEOR 4731 taught by Professor Hexuedong during the Spring '12 term at Columbia.

Page1 / 28

LectureNotes02PF - IEOR E4731: Credit Risk and Credit...

This preview shows document pages 1 - 6. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online