Chapter 23

Credit Derivatives and Structured Products

Credit derivatives are the latest tool in the management of portfolio credit risk. Credit derivatives are contracts whose value derives from the credit risk of an underlying obligor, corporate, sovereign, or multiname. They allow the exchange of credit risk from one counterparty to another. Credit derivatives initially grew from the need of banks to modify their credit exposure but since then have become essential portfolio management tools.

Like other derivatives, they can be traded on a stand-alone basis or embedded in some other instrument, such as a credit-linked note (CLN). This market has led to the expansion of structured credit products, through which portfolios of credit exposures are repackaged to better suit the needs of investors. This transformation relies on the securitization process, which was first applied to mortgage pools and was described in Chapter 18. Section 23.1 presents an introduction to the size and rationale of these markets. Section 23.2 describes credit default swaps and their pricing. Other contracts such as total return swaps, credit spread forwards, and option contracts are covered in Section 23.3. Section 23.4 then presents credit structured products, including credit-linked notes and collateralized debt obligations (CDOs). Because of its importance, Section 23.5 describes the CDO market in more detail. Finally, Section 23.6 discusses the pros and cons of credit derivatives and structured products ...

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