In this final section, we give a brief overview of portfolio credit derivatives products such as index tranches and collateralised debt obligations (CDOs). A basic understanding of these structures is useful for the discussions on wrong-way counterparty risk in Chapter 15. A more in-depth coverage of portfolio credit derivatives and their uses (and abuses) is given in Tavakoli (2008).
Up until 2004, the majority of credit default swaps were written on single names, but thereafter a major impetus to growth and market liquidity of the credit derivative market has been credit default swaps on indices. A credit index can usually be thought of as an equally weighted combination of single-name CDSs and hence the fair premium on the index will be close to the average CDS premium within that index.21 The two most common credit indices are:
Other indices exist for different underlying reference entities and regions but they are less liquid. Indices can be traded in either CDS (unfunded) or CLN22 (funded) form. Buying CDS protection on $125m of the DJ CDX NA IG index is almost23 equivalent to buying $1m of CDS protection on each of the underlying reference entities within the index.