Credit Spreads and Securitization
7.1 CHAPTER OVERVIEW
This chapter explores credit risk on debt securities issued by non-sovereign borrowers, as well as credit default swaps and securitization. In developed markets the credit spread on a bond issued by a corporation is traditionally measured as the additional return or yield on that bond over a Treasury security with a similar maturity. The spread depends on the probability that the bond will default, and on the cash amount that can be recovered in the event of default. However it is also affected by liquidity factors. The chapter explores the activities of the credit ratings agencies in assessing default risks. It also considers so-called ‘risk-neutral’ models which can estimate a bond’s default probability from its credit spread or vice versa. Next the chapter explores credit derivatives, and in particular credit default swaps (CDS), which allow traders and investors to hedge or speculate on changes in the creditworthiness of entities such as corporations, financial institutions, and sovereign states. It considers the standard CDS structure and how CDS contracts are used to create credit-linked notes. Finally the chapter discusses securitization which is the process by which bonds are created and sold to investors backed by the cash flows generated by a pool of assets. It considers collateralized debt obligations (CDOs) which are bonds sold to investors via a special purpose vehicle (SPV) in different classes or tranches ...