Multi-Name and Structured Credit Risk Portfolios
Prices of financial instruments traded over the counter (OTC) and in financial (credit derivatives) markets may differ. While the price of an OTC financial contract is based on an exchange between specific parties, in a financial credit derivatives market, these instruments are standardized and are traded among the many buyers and sellers of these products. For these reasons, the approaches we use to price these instruments differ. For example, credit default swaps (CDSs) and interest-rate swaps, privately negotiated and unregulated, may default due to parties’ intent or their inability to meet contractual obligations. In a financial market, default is mostly due to economic factors such as liquidity of the instrument, the market appetite for risk or its flight from risk, and so on. The rise of insurance firms as third-party guarantors of CDS trades has contributed immensely to the growth of a market for credit risk and credit derivatives, mitigating some of the risks inherent in these financial products. The recent credit crisis has contributed to the reassessment and the management of such products, calling for their standardization and regulation. A call for greater transparency and regulation, a greater understanding of (intra-portfolio) tranches correlation, and a better appreciation of how to price both credit and counterparty risks have raised both practical and academic challenges. This chapter attends ...