Quantitative Finance

18Exchange Traded Funds (ETFs), Credit Default Swap (CDS), and Securitization

18.1 Introduction

In the previous chapter, we discussed models for pricing bonds. We recall that the bond market is where debt securities are issued and traded. Although the bond market appears complex, it is driven by the same risk and return tradeoffs as the stock market. In this chapter, we will begin by discussing Exchange Traded Funds (ETFs) which are marketable securities. Marketable securities are defined as any unrestricted financial instrument that can be bought or sold on a public stock exchange or a public bond exchange. Next we will describe the Credit Default Swap (CDS) which is a financial swap agreement where the seller of the CDS will compensate the buyer in the event of a loan default (by the debtor) or other credit event. Finally, we will end this chapter by discussing securitization, namely, Mortgage Backed Securities (MBS) and Collateralized Debt Obligation (CDO). Securitization is the procedure whereby an issuer designs a financial instrument by pooling various financial assets together and then markets tiers of the repackaged instruments to investors.

18.2 Exchange Traded Funds (ETFs)

In this section, we introduce and describe ETFs and present some examples.

An exchange traded fund (ETF) is an investment fund traded on stock exchanges [108, 183]. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it ...