A Framework for Evaluating Trades in the Credit Derivatives Market

As discussed in Chapter 11, the markets for credit default swap (CDS) and synthetic collateralized debt obligation (CDO) have grown tremendously, both in terms of trading volume and product evolution. In terms of product evolution, CDSs have developed from highly idiosyncratic contracts, taking a great deal of time to negotiate, into a liquid market offering competitive quotations on single-name instruments and even indices of credits. Synthetic CDOs have evolved from vehicles used by commercial banks to offload commercial loan risk to customized tranches where investors can select underlying credits. And the rise of standard tranches of CDS indices has blurred the distinction between credit default swaps and synthetic CDOs.

As a result of these instruments, credit trades offered to participants in the credit derivatives market every day involve assessing trade-offs, such as the following two examples:

  • Is it better to sell credit protection on a single BBB rated corporate name or on the BBB rated tranche of a synthetic CDO?
  • Is it better to sell credit protection on a portfolio of BB names or on the equity tranche of a CDO comprised of A-rated names?

These examples offer us the chance to analyze risk to a single credit, a portfolio of credits, and a tranche of a CDO. They also allow us the opportunity to compare risk to credits with the same underlying rating and to credits with different underlying ...

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