Basic Insights in Pricing Basket Credit Derivatives

Abstract

Basket credit derivatives are those financial contracts whose pay–out depends on the credit events (‘failure to pay’, ‘default’, etc.) characterizing a portfolio of bonds or loans over a determined time horizon.We have two main categories of basket credit derivatives. The first is characterized by a pay–out depending on the temporal ranking of the credit events: first–to–default, second–to–default, etc. The second is characterized by a pay–out depending on the percentiles of the portfolio's loss distribution induced by the credit events. The latter is often embedded in securitizations of portfolios of bonds or loans, i.e. CDO.This paper proposes some basic insights in the pricing of these particularly complex credit derivatives. Whenever possible, we will try to find an analytical approximation to the exact pricing formula, if a closed form solution is not available.(J.E.L.: G13).