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Mastering Credit Derivatives: A step-by-step guide to credit derivatives and structured credit, Second Edition

Book Description

A step-by-step guide to credit derivatives and their application.

Mastering Credit Derivatives provides comprehensive coverage of this rapidly growing market. It will give you a clear understanding of what credit derivatives are, as well as explaining their benefits and risks.

In this fully revised and updated edition, Andrew Kasapis approaches the derivatives market from a practical basis, using examples of real market data and trades. He includes ideas and comments from market practitioners who offer valuable insights as to the likely direction the industry will take.  

The book includes chapters on:

  • An assessment of the sub-prime crisis and how it has affected derivatives

  • Available derivative products and how they are applied

  • How best to value credit and how to price and risk-manage derivatives

  • An explanation of traunched indices and first-to-default  baskets

  • Recently introduced products such as collateral synthetic obligations (CSOs) and collaterised debt obligations (CDOs)

  • Mastering Credit Derivatives is an invaluable guide that will help you to understand credit derivatives and apply them to your market place.

    Table of Contents

    1. Copyright
      1. Dedication
    2. Financial Times Prentice Hall
    3. About the author
    4. Preface
    5. Publisher’s acknowledgements
    6. 1. Introduction
      1. What’s in a Name?
      2. What are Credit Derivatives?
      3. How Big is the Market?
      4. Who is Involved?
        1. Banks
        2. Dealers (market makers)
        3. Hedge funds
        4. Asset managers
        5. Insurance companies
        6. Pension funds
        7. Retail investors
        8. Corporates
        9. Interdealer brokers
      5. Evolution of the Market
    7. 2. Credit derivative instruments and applications
      1. Credit Derivatives Products
        1. CDS description
        2. CDS settlement examples
          1. Physical settlement
          2. Cash settlement
          3. Binary or digital settlement
        3. Uses of a CDS
      2. Trades Using Credit Derivatives
        1. Trading the credit spread
        2. Relative value trades
        3. Negative basis trade
        4. Positive basis trades
        5. Credit curve trades
          1. Credit curve steepening trade
        6. Senior versus subordinated trades
      3. Risk Measures for CDS
        1. Jump-to-default (JTD) risk
        2. Spread PV01
      4. Comparing Bond Spreads and CDS Prices
        1. Example of a single-name credit default swap
        2. Credit default swap: Wal-Mart example
        3. Practical credit default swap application
          1. Summary
        4. Cash determining the CDS spread
      5. Basket Default Swaps
        1. Baskets and default correlation
        2. Applications
        3. Hedging default baskets
      6. Synthetic CDOs
        1. Mechanics of a synthetic CDO
        2. The CDO tranche spread
        3. The portfolio loss distribution
        4. The tranche loss distribution
      7. Summary: Application of Credit Derivatives
        1. Why use credit default swaps ?
        2. Does a default swap hedge credit deterioration risk?
    8. 3. Pricing a CDS and the cash bond basis
      1. Credit Modelling
        1. Single credit modelling
          1. The hazard rate approach
        2. Pricing model for CDS
        3. Valuation of a CDS position
          1. Default probabilities
      2. Calibrating Recovery Rates
        1. Modelling default correlation
        2. Modelling joint defaults
      3. A Practical Approach to Pricing a CDS
        1. Predictive or theoretical pricing models of credit swaps
        2. Mark-to-market and valuation methodologies for credit awaps
        3. Constructing a credit curve from bond prices
          1. Example: Risky zero-coupon bond with one year to maturity
        4. Calibrating the probability of default
        5. Problems encountered in practice
      4. Using Default Swaps to Make a Credit Curve
      5. Linking the Credit Default Swap and Cash Markets
        1. Using the credit curve
        2. Counterparty considerations: Pricing the two-name exposure in a credit default swap
      6. Cash and CDS Basis
      7. Bond Spread Measures and the CDS–bond Basis Definition
        1. Spread measures for fixed-rate bonds
          1. Bond spreads
          2. I-spread
          3. Z-spread
        2. Asset swap spreads
        3. The CDS–bond basis
      8. Basis Drivers
        1. Arbitrage opportunities
        2. Factors that make the basis positive
          1. Fundamental determinants
            1. CDS cheapest-to-deliver option
              1. CDS premia are floored at zero
              2. CDS restructuring clause – technical default
              3. Bond trading below par
              4. Profit realization
          2. Technical determinants
            1. Demand for protection – difficulties in shorting cash bonds
              1. Issuance patterns
        3. Factors that make the basis negative
          1. Fundamental determinants
            1. Funding issues
            2. Counterparty default risk
            3. Accrued interest differentials on default
            4. Bond trading above par
          2. Technical determinant
            1. Synthetic CDO issuance
        4. Factors that make the basis either positive or negative
          1. Fundamental determinant
            1. Coupon specificities
          2. Technical determinant
            1. Relative liquidity in segmented markets
      9. Summary: Credit Default Swaps Compared with Bonds
        1. CDS bond basis
        2. Single-name trading strategies
    9. 4. Credit derivatives documentation and regulations
      1. Documentation
      2. Infrastructure and ISDA’s Role
        1. Credit default swap documentation
        2. ISDA documentation for credit default swaps
        3. Market practice
      3. Restructuring: The 2003 Definitions
        1. The question of restructuring
        2. The 2003 definitions offer four choices relating to restructuring
          1. Modified restructuring
          2. Modified-modified restructuring (Mod Mod R)
          3. No restructuring (No R)
        3. Main changes
          1. Test for identifying the successor to a reference entity
          2. Amendments to credit events, including bankruptcy and repudiation/moratorium
          3. Procedures for non-deliverable bonds and loans
          4. Guarantees
          5. Novation provision
      4. Other Considerations
        1. Accounting
        2. Taxation
        3. Regulation
          1. Risk management
        4. Summary
      5. Bank Regulation of Credit Derivatives
        1. Treatment of unfunded credit derivatives in the Banking Book
        2. ‘Funded’ credit derivative structures
        3. ‘Basket’ structures
        4. Asset mismatches
        5. Maturity mismatches
    10. 5. Tranched indices
      1. Credit Default Swap Indices
        1. Standardized payment and maturity dates
          1. Deal spread
          2. Payment of accrued premiums
          3. Restructuring definition
        2. Background to credit default swap indices
          1. Launching new indices
          2. Standardized index trades
          3. Index maturities
          4. Examples
          5. Indices and their trading dynamics
          6. Theoretical price versus market price
          7. Single name versus indices basis
          8. Early indices
          9. New indices
      2. Determining the Upfront Payment
      3. Impact of Defaults on Index Cashflows
      4. Tranches of Standard Default Swap Indices
        1. The basic mechanics
        2. How are the standardized tranches determined?
      5. Characteristics of Benchmark Tranches
        1. Attachment and detachment points
        2. Market quoting convention
        3. Tranche ‘delta’
        4. Rolling over indices
        5. Standardized maturity dates
        6. Payment of accrued premiums
        7. Restructuring definitions
        8. Hybrid settlement in case of default
      6. Investment Strategies with Credit Derivative Indices
        1. Credit derivative indices: A simple application
        2. Trading example: Premium payments
        3. Trading example: Credit event
      7. Investors
    11. 6. What is correlation?
      1. What do We Mean by Correlation?
      2. Correlation in Structured Credit Markets
        1. Default correlation not spread correlation
        2. Aggregate correlation – if you can call it that
      3. Observing Default Correlation
        1. Hidden meaning of default correlation in credit markets
      4. Valuation in Structured Credit Markets
      5. Getting to a Portfolio Loss Distribution
      6. Copula Functions
      7. Correlation as a Relative Value Metric (Base Correlation)
      8. Base Correlation
      9. Practical use of Correlation
        1. Why we care about correlation
      10. Analysing a Portfolio of Credit Risk
      11. Modelling Correlated Defaults
        1. Modelling default time of individual credits
        2. What is a copula?
      12. Simulating Correlated Defaults with a Copula
        1. Valuing tranched transactions
        2. Valuing a loss tranche
        3. Calculating a breakeven spread
      13. What is Correlation Missing?
      14. A Summary of CDO Pricing
      15. Correlation Trading Rules of Thumb
        1. The subordinate v. senior divide
      16. Copula Drawbacks
    12. 7. First-to-default (FTD) baskets
      1. Basket Default Swap Mechanics
        1. Selling FTD protection: Looks like a default swap, feels like CDO equity
        2. Basket default swaps are correlation products
      2. Investor Motivation
      3. Mergers and FTD Baskets
        1. Replacement language in FTD baskets
        2. Replacement language: Operationally puzzling
        3. The merger effect: What is it worth?
      4. Second-Through-Fifth Default Baskets
        1. Second-through-fifth default baskets: Investor motivation
      5. Funded Baskets
        1. Example: Ex-HiVol first-to-default basket
    13. 8. Cash CDOs
      1. CDO Terminology
      2. Assets, Tranches, Purposes and Credit Structures
        1. Assets
        2. Tranches
        3. Purposes
        4. Credit structures
      3. The À la Carte CDO Menu
        1. Types of collateral portfolios
        2. Motivation
        3. Motivations for the owners of the assets and SPV
        4. Diversification
      4. How do Cash CDOs Work in Practice?
        1. Monoline reinsurance
        2. CDO collateral manager
        3. CDO trustee
        4. CDO debt tranches
        5. Capital structure example
      5. Cash CDOs: A Taxonomy
        1. Balance sheet transactions
        2. Arbitrage transactions
        3. Market value structures
        4. CDO lifecycle and performance tests
      6. Structural Features and Performance Tests in Cash CDOs
        1. Subordination
        2. Over-collateralization (O/C) and coverage tests
        3. Trigger levels
        4. Supplemental O/C test
        5. Excess CCC haircut
        6. If coverage tests are not met
        7. Collateral quality tests
          1. Diversity score
          2. Weighted average rating factor (WARF)
          3. WAL and WAM
      7. Understanding CDO Equity Returns
      8. Understanding CDO Debt Returns
      9. Details of a Cash CDOs Structure
        1. Deal summary
        2. Asset manager
        3. Performance summary
        4. Collateral summary
        5. Rating definitions
    14. 9. Synthetic CDOs
      1. What are Synthetic CDOs?
      2. Example of a Fully Unfunded Synthetic CDO
      3. Example of an AAA Reference Portfolio CDO
      4. Case Studies of Managed Synthetic CDOs or CSOs
        1. BISTRO – the first synthetic securitization
      5. Single-Tranche CDOs (STCDOs)
        1. Selection of reference portfolio
        2. Single-tranche CDO investment strategies
        3. Investment strategies
          1. Leverage strategies
          2. Correlation strategies
          3. Short position in senior tranche or long position in equity tranche (long correlation)
          4. Long or short position in junior mezzanine tranche (correlation insensitive)
        4. Relative value strategies
          1. Long/short position in on-the-run CDX IG tranches v. short/long position in matching off-the-run CDX IG tranches
          2. Long/short position in 5-year CDX IG tranches v. short/long position in 10-year CDX IG tranches
          3. Long/short position 3–100% CDX IG tranche with short/long position in CDX IG index v. short/long position in 0–3% CDXIG tranche
        5. Micro/macro hedging strategies
          1. Short position in equity tranche
          2. Short position in equity tranche and long position in mezzanine tranche
          3. Short position in senior tranche
          4. Long positions in mezzanine or senior tranche
      6. CSO Trade Opportunities
      7. Synthetic CDO Structures
        1. Attachment and detachment points
        2. Why synthetic CDOs?
        3. Funding gap and the super senior tranches
        4. Increased flexibility and customization
        5. Range of permissible assets
        6. Efficiency of unfunded liabilities
        7. Taxonomy of synthetic CDOS
        8. Balance sheet versus arbitrage
        9. Static v. managed
        10. Funded v. unfunded
        11. Rating agency approaches to synthetic CDOs
        12. Moody’s
        13. Standard & Poor’s (S&P)
        14. Fitch
      8. Analytical Challenges in Modelling Synthetic CDOs
      9. The ABCs of CDOs-squared
        1. Types of CDO-squared
        2. Structure of a CDO-squared
        3. Rationale for CDOs-squared
        4. CDO-squared mechanics
    15. 10. Understanding tranche sensitivity
      1. Tranches as Options on Default
      2. Sensitivity to Spread Changes (‘Delta’)
        1. Impact of upfront payments
      3. ‘I – Gamma’: Sensitivity to Spread Distribution Changes
      4. Delta Migration
      5. ‘M – Gamma’: Convexity
      6. Jump-to-Default Sensitivity
      7. ‘Theta’: Time Decay
      8. ‘Rho’: Sensitivity to Correlation Changes
      9. Conclusion
    16. 11. Innovation, the credit crisis and the future
      1. Innovation Outstrips Risk Management
      2. Subprime Mortgage Crisis of 2007
      3. Credit Crisis Events in Context
        1. Substantially lower risk tolerance among investors
        2. From easy money...
        3. ...via financial innovation...
        4. ...to tight money
        5. Decreasing value
        6. Increasing credit spreads
        7. Slumping stock market
        8. Reversing carry trade
        9. Investors seek a safe haven
        10. Volatility and mark-to-market
        11. Liquidity crisis
        12. Central banks meet most urgent need
      4. Action Taken
      5. Subprime Credit Crunch: A Summary
      6. Subprime and Credit Crunch Debate
        1. ECB and Fed and interbank lending
        2. CP financing of mortgage-backed securities
        3. The credit crunch
        4. Bad loans and unrealistic ratings
        5. Bear Sterns
        6. The problem with mark-to-market
        7. Leveraged buyouts (LBOs)
        8. Conduits
        9. Hedge funds
        10. The upshot of the credit crunch
      7. How Regulators and Banks Improve Risk Management
    17. Notes and references
      1. Chapter 2
      2. Chapter 3
      3. Chapter 4
      4. Chapter 6
      5. Chapter 9
      6. Chapter 10
      7. Further references
    18. Glossary