Abstract
In this chapter, we apply our financial engineering toolkit to credit markets. We discuss credit default swaps (CDS), associated contractual conventions, and their replication. Similar to earlier applications of swap cash flow engineering, we show how synthetic CDS can be used for arbitrage trading. We discuss negative basis trades and credit curve steeping trades in this context. We then introduce the modeling of default probabilities and unwinding of CDS positions before discussing the valuation of CDS contracts. The chapter highlights market conventions including the standardization of CDS contracts as a result of the 2009 CDS “Big Bang” as well as real-world complications related to recovery value clauses, credit event triggers, and settlement. We point out differences between CDS and total return swaps and equity default swaps. We draw lessons from recent sovereign defaults and discuss special issues related to sovereign CDS markets. This chapter lays the foundation for subsequent chapters that discuss credit-structured products based on CDS.
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