without increasing their downside beyond the ﬁrst name that defaults.
Further the premium received will usually be much higher than sell-
ing protection on just one name. A very recent development has been
the supply of index swaps, which pay the return received on a standard
index in return for a ﬂoating periodic payment. These are obviously
popular enabling an unfunded exposure to a wide variety of, potentially,
A ﬁrst to default note will consist of exposure to a number of credits
with the size being the notional at stake. After the ﬁrst credit event the
note terminates and the investor must pay the protection seller either
a compensating one-of-payment (cash settlement). Or receive the ‘dam-
aged basket’ and make good the difference between this and par.
In Figure 3.18 the note is written on the three corporates whose yields
are depicted in the ﬁgure. We can see that Corp C defaults which would
The note will either be cash settled or physically settled in which case
the owner of protection will deliver the damaged asset in return for
par. This is often the case for ﬁrst to default notes issued by an SPV.
The amount for cash settlement is the difference between par and the
ﬁnal price of the reference obligation.
The yield that the investor receives on a ﬁrst to default spread note
will be somewhere between the spread of the worst individual credit and
the sum of the spreads on all. This will be close to the sum of spreads
if the correlation is low and vice versa for high correlation. The reason
for this is that in the case of no correlation the portfolio will have the
properties of a sum of individuals while if they are all correlated they
effectively behave as the worst asset. Figure 3.19 shows the ﬁrst to
default spread curve and how it depends on correlation. The ﬁrst to
default spread is equal to the worst in the case where the correlation
is equal to 100 per cent.
Credit derivatives 161
Figure 3.18 The yields on three companies (% vs. Time).