Principles of Financial Engineering, 2nd Edition

CHAPTER 19

Default Correlation Pricing and Trading

1. Introduction

There are three major issues with the credit sector. First there is the understanding and engineering of the credit risk itself. In other words, how does one strip the default risk component of a bond or a loan and trade it separately? The engineering of a credit default swap (CDS) serves this purpose, and was done in Chapter 5.

The second dimension in studying credit risk is the modeling aspect. Without modeling one cannot implement pricing, hedging, and risk management problems. Modeling helps to go from descriptive or graphical discussion to numbers. In credit risk the modeling has a “novel” component. The risk in question is an event, the default. They are zero-one type random ...