9 - Basket default swaps

Abstract

Basket default swaps are credit derivatives written on a “basket”, or portfolio of assets issued by more than one reference entity. In particular, a payment by the protection seller in a basket swap can be triggered by a default of any one of the entities represented in the basket, provided that default meets the requirements specified in the contract. This chapter briefly encounters a common variety of a basket default swap—the first-to-default basket (FTD). Protection buyers find basket swaps attractive because they tend to be less expensive than buying protection on each name in the basket separately through single-name credit default swaps. From the perspective of investors (protection sellers), basket swaps provide an opportunity for yield enhancement with a limited downside risk. Under valuation considerations, the chapter discusses the main determinants of the premium paid by the protection buyer in a credit basket swap: the number of entities in the reference basket, the credit quality and expected recovery rate of each basket component, and the default correlation among the reference entities.