65 - Credit derivatives II

Abstract

This chapter considers some approaches to credit derivatives pricing, focusing on numerous techniques for credit default swaps and default options. The price of a credit derivative is essentially the price put by the bank on the likelihood of default of the issuer of the underlying asset. The price paid must reflect fair value in terms of compensation for taking on the credit risk of the issuer. The expected value of a risk-carrying cash flow is based on the likelihood of loss, and the extent of the loss, given by the recovery rate. Default options give the purchaser protection against default by paying a lump sum in the event of a default on a reference bond. Default options differ from Total Return Swaps in two very important ways. First, Total Return Swaps pay as interest the total coupon during the period plus the difference between the starting price and the ending price. In the case of default, the coupon would not be paid. Second, the purchaser will pay the carrying cost on a Total Return Swap. The purchaser of a Default option will pay an amount based on the pricing.