Exotic Options

Exotic Options
Forward Start Option Compound Options Chooser Option Barrier Option Binary Option Look back Option Shout Option Asian Option Basket Options

Exotic Options Forward Start Option

A forward start option is the forward purchase of a standard call option (i.e. right to buy) or put option (i.e. right to sell). Example : Purchasing a 3 month put option that will come into existence 6 months from today

On the forward start date the strike price of the option will be set at a predetermined level. Typically this is the spot price of the asset on the forward start date (i.e. at-the-money).
Alternatively the strike price can be set at a percentage in the money or out of the money (i.e. a percentage above or below the current spot price of the asset) They are a common part of employee incentive plan

Exotic Options Compound Options

These are option on option Call on Call: Investor has right to buy a call option at a set price for fixed period

Call on Put: Investor has right to buy a put option at a set price for fixed period
Put on Call : Investor has right to sell a call option at a set price for fixed period Put on Put : Investor has right to sell a put option at a set price for fixed period

Exotic Options Chooser Option

The option owner has a choice to decide whether the option is a call or a put
The choice is to be exercised after a certain period of time The choice will obviously depend on which option has a higher value once the fix time period has elapsed

Exotic Options Barrier Option

The options payoff is dependent on a barrier level They have knock in (come into existence) and knock out (cease to exist) features

Barrier level are set either below the current stock rice (down) or above the current stock price (up)

Exotic Options Barrier Option

Down and Out call (put) :The barrier level is set below the current stock price and the option (call or put) cease to exist if the barrier level is hit Down and In call (put) : The barrier level is set below the current stock price and the option (call or put) comes into existence if the barrier level is hit Up- and Out call (put) : The barrier level is set above the current stock price and the option (call or put) comes into existence if the barrier level is hit Up and In call (put) : The barrier level is set above the current stock price and the option (call or put) comes into existence if the barrier level is hit

Exotic Options Barrier Option

The characteristics of barrier options are different from the normal standard options For e.g. Vega, is always positive for a standard option but may be negative for a barrier option. Increased volatility on a down and out option and an up and out option does not increase value because the closer the underlying gets to the barrier price, the greater the chance the option will expire

Exotic Options Binary Option

They pay only a fixed price at expiration if the asset is above the strike price thus they have discontinuous payment profiles It has two states hence binary State 1: asset above exercise price : pay a fixed dollar amount State 2: asset below exercise price : pay nothing

Two types Cash or Nothing Asset or Nothing

Exotic Options Binary Option

Cash or Nothing: In Cash or Nothing Call a fixed amount Q is paid if the asset ends up above the strike price .
Asset or Nothing : An Asset or Nothing Call pays the value of the stock when the contract is initiated , if the stock price ends up above the strike price at expiration .

Exotic Options Look Back Option

The option payoffs depend on the maximum and minimum price of the asset during the life of the option Look Back Call : At expiration it pays the difference between expiration price and the minimum stock price during the life of option Thus allowing the investor to purchase the security at the lowest price during the life of the option Look Back Put : At expiration it pays the difference between expiration price and the maximum stock price during the life of the option Thus this option allows the investor to sell the security at the highest price during the life of the option

Exotic Options Shout Option

The owner of the option shouts to the seller of the option as if he has exercised his option The owner still gets to keep the option The difference between the shout price and the stock price is the minimum locked in profit that the owner gets Even if the stock price falls below the shout price he is entailed to the minimum locked in profit However if at the end of the option period the intrinsic value (stock strike) is greater than the difference between ( shout stock ) the owner gets to keep the higher profit

Most shout option allow for one shout

Exotic Options Asian Options

They are different than the standard option
They have payoff profiles based on average stock price over the life of the option Asian call option pay off = max [ 0 , S Average -K ] Asian put option pay off = max [ 0 , K - S Average ]

Average price will always be less volatile than the actual stock price due to which the price of the option will always be less than the standard call and put options

Exotic Options Basket Options

Options to sell or purchase basket of securities
The basket can be individual investor specific or can have specific stocks , indices or currencies

Exotic Options Hedging Issues

There are some exotic options that are easier to hedge than plain vanilla options. Example: Asian options are easier to hedge because it is dependent on average stock price and so as time passes, more is known about the prices that will determine the average price. Static option replication involves the construction of a short portfolio of actively traded options that approximates the option position to be hedged. The replication portfolio is created only once

Credit Derivatives

Do we have Credit Risk in the following areas?

Area Loan extended by Bank Bonds issued by corporates Credit extended by credit card issuer Credit Derivative Swaps/Options* Do we face credit Risk (Yes/No)
Yes Yes Yes Yes No

Credit Risk Faced by

Bank Bond holder Card issuer Both Counterparties None

Treasury Securities

* As option always have positive value or zero (no negative), option buyer faces credit risk from option seller.

Credit Risk Management Strategies

Risk Taking (Speculative) Use of Derivatives like CDS, TRS and structured products
Risk Transfer (Insurance) Risk Mitigation (Hedging)

Use of Derivatives like CDS, TRS and structured products.

Diversification Use of Derivatives like CDS, TRS etc.

While Banks are net buyers of protection, Insurance and Hedge Funds are net sellers of protection.

What are Credit Derivatives?

Credit Derivatives are derivatives which are used for either
Hedging credit risk involved in loans/bonds (while the loans can also be sold, it needs borrowers concurrence) or Speculating changes in credit risk and thus assuming indirect exposures to credit risks for diversification.

E.g., Credit Default Swaps (CDS), CDS forwards and CDS options, Total Rate of Return Swaps (TROR) Credit Derivatives can be tailored to lay off any part of the credit risk exposure i.e., amount, recovery rate and maturity. Credit Derivatives are not traded on exchanges and are arranged on OTC basis.

Credit Default Swap

CDS is essentially an insurance contract. If a default occurs on the reference obligation, the CDS buyer receives a payment from the CDS seller. The reference obligation is the bond or bank loan on which the swap is written.
CDS Buyer (protection buyer)
coupon

premium

Premium payment options

CDS Seller (protection seller)

Payment On default

The default swap premium also known as default swap spread can be paid
One time upfront or Over a period of time

investment

Reference obligation (bond/loan)

CDS
CDS Buyer (protection buyer)
Prem., b

CDS Seller (protection seller)

Position of CDS buyer

Risk Free bond Coupon (a-b)

Coupon, a

Reference obligation (bond/loan)

Note: On condition that there is no counterparty (risk of swap seller default) risk, liquidity risk and assuming that the interest rate sensitivity of the risky and risk free bonds are similar

Chronology of events in CDS

1 2 3
4
Buyer Buys CDS from seller and pays premium regulary. (Agreement defines nature of reference obligation, credit event etc) Credit event is triggered (Bankruptcy, failure to pay, restructuring etc) Materiality of the event is verified from the Publicly available information Credit Event Notice is served by the buyer on seller Seller settles the amount (Physical/cash settlement)

CDS Terminology
Reference Entity: It is the corporate, sovereign entity on whose credit the CDS contract is sold. Reference Obligation: Reference Obligation is prespecified obligation issued or guaranteed by the Reference Entity The buyer however does not have to deliver this specific obligation. Any Obligation of the Reference Entity, which meets criteria like seniority, currency, tenor etc. can be used as deliverable/reference obligation. If no Reference Obligation is specified, Senior Unsecured obligation is assumed

CDS Terminology
The Credit Events: The events that trigger payment from a CDS are formalised by ISDA (International Swaps and Derivatives Association)
a. Bankruptcy: Need not be actual filing, even the steps taken by a corporation to initiate the process is deemed as credit event. b. Obligation acceleration: Refers to when an obligation becomes payable before its scheduled time due to default of the reference entity c. Failure to pay: When the reference entity does not make the required payment d. Repudiation/Moratorium: refers to when the issuer disowns its obligation to pay e. Restructuring: refers to when unfavourable events occur, such as reduction in the payment, reduction in the payments seniority or a postponement in the payment. Note: A downgrade from a rating agency, however is not defined as a credit event.

Payment of CDS on Cash

If a credit event occurs, the settlement of CDS can be made on physical and cash basis.
In case of physical, the reference obligation is physically delivered to the seller, who will have to pay the par value.

In case of cash, payment is made as under: Settlement amount = NP x [reference amount (final price + accrued interest)] Where NP = notional principal of the Swap Reference amount = amount specified at the inception of the contract (usually 100%) Accrued interest = percent interest calculated relative to the last coupon payment Final price = percentage price determined by examining the last bid price (in a poll of five securities dealers)

Payoff from CDS - Example

Suppose it has been 60 days since the last coupon payment. The notional principal of the swap is USD 20 mn and the reference amount is 100%. The final price is estimated at 30% and the annual coupon was 8%. Calculate the cash settlement amount.
Settlement amount = 20,000,000 x (100% - [30% + (8% x 60/360)]) = USD 13,733,333

Swap Buyer Vs Swap Seller

Swap Buyer or Protection Buyer Swap Seller or Protection Seller

CDS acts as a long Put option on the reference obligation On default, the buyer receives payment, which limits the buyers downside risk

It is equivalent to writing put option on the reference obligation (short put) On default or occurrence of a credit event, seller is obliged to pay either Net amount Face value of the ref obligation upon physical delivery of obligation
Creates long position in the reference obligation

It creates a Short position in the reference obligation i.e., he can use it for hedging the existing exposure to reference obligation or for taking position in the ref obligation indirectly (speculation) When the credit quality of the reference obligation declines, CDS become more valuable and can be traded for profit. CDS will not offer protection against market risk (interest risk or currency risk)

If credit quality of the ref obligation increases, the swap value decreases thus seller can buy back the swap and realise a profit.

Types of CDS Cancelable default swap

In this type of swap, the buyer or the seller or both have the right to cancel the swap If the buyer of the swap has the right to cancel it, it is called callable default swap If the seller has the right to cancel, the swap is referred to as puttable default swap Callable are more common than the puttable default swaps. Payment is made only if another event occurs besides a credit event on the reference obligation. The other event can be credit event on another obligation Protection is weaker and as such trades at low premium

Contingent Default Swap

Types of CDS Leveraged Default Swaps

The payment in this swap is a multiple of the buyers loss on the reference obligation. These swaps are expensive and are undertaken for speculation Instead of hedging several obligations, a single leverage default swap could be purchased. However, the buyer is exposed to basis risk if the losses on the portfolio are not equivalent to the coverage from the swap. In this case, a loan is purchased by a special purpose vehicle (SPV) and transformed into notes with different risk tranches The investor can then choose the tranche that matches his risk level

Tranched portfolio and tranched basket default swaps

Types of CDS

Binary or digital default swap

Swaps final price is set at the inception of the contract and is based on historical recovery rates Popular because of their simplicity

Basket Credit Default Swap

The reference obligation is a basket of debt securities. nth-to-default swap payment is triggered when the nth reference obligation defaults. If n is set at one, it is called first-to-default basket credit swap.

Basket CDS Effect of Correlation

The spread for basket CDS depends on correlation of the reference entities in the basket. Low correlation: In a basket of say 100 reference entities, when there is low correlation between entities (diversified portfolio), the probability of single default is high as compared to the probability of 10 defaults. Therefore, the value (spread) of first to default swap will be higher than 10th-to-default swap. High correlation: However, as the correlation increases, the probability of multiple defaults also increases. When the portfolio contains similar type of obligations (i.e., correlation is one), either there will not be any default, or all of them will default. In this case, the value of first-to-default and nth-todefault CDS will be same.

CDS Credit Indices

Participants in credit derivatives markets have developed indices to track CDS spreads. Among the indices now used are, The 5 and 10 year CDX NA IG indices tracking the credit spread for 125 investment grade North American companies The 5 and 10 year iTraxx Europe indices tracking the credit spread for 125 investment grade European companies For eg., an investment bank acting as markt maker might quote the CDX NA IG 5 year index as bid 65 bp and offer 66 basis points. An investor then could buy CDS at 66 bp and sell at 65 bp.

Computation of value of CDS

The aim is to determine value of the mid-market (average of bid and ask prices) CDS spread on the reference entity. The following are the steps Calculate the present value of the expected payments (payments are made at the spread rate and multiplied by the reference entitys probability of survival each year) Calculate the present value of the expected pay-off in the event of default (assume that the defaults occur half-way through a year. From there the annual probability of default is multiplied by recovery rate and discounted to present value) Calculate the present value of accrual payment in the event of default.(Since the payments are made in arrears, an accrual payment is required in the event of default to account for the time between the beginning of the year and the time when the default actually occurs) Calculate the spread using the following equation Spread, s = PV Payoff/PV Payments

Computation of value of CDS concept checker

ABC enters into a 4 year CDS with XYZ insurance to hedge the credit risk of USD 100 mn bond issued by PQR corporation. The probability of PQR corp defaulting during a year, conditional on no earlier default is 3%. Assume that the defaults always happen halfway through a year and the payments of premium are made once in a year at the end of the year. The risk free rate is 6% p.a., compounded continuously and the recovery rate in the event of default of PQR is 30%. Calculate a. PV of total expected payments made by buyer of CDS b.PV of expected payoff in the event of default c. The CDS spread.

Concept checker a. PV of expected payments in the event of survival (no default)

Time (years) Survival probability
0.9700 0.9409

Expected payment
0.9700s 0.9409s

PV of expected payments
0.9135s 0.8345s

1 2

3
4

0.9127
0.8853

0.9127s
0.8853s Total (a)

0.7624s
0.6964s 3.2068s

Note: probability of survival at the end of second year = 0.97x0.97 0.97s e( 0.061) PV of expected payment at the end of 1 year =

Concept checker b. PV of accrual payment in the event of default

Time (years) Default probability 0.3000 0.0291 0.0282 0.0274 Expected accrual payment 0.0150s 0.0146s 0.0141s 0.0137s Total (b) PV of expected accrual payment 0.0146s 0.0133s 0.0121s 0.0111s 0.0511s

0.5 1.5 2.5 3.5

Note: probability of default in second year = 0.97x0.03 Since we are assuming that default occurs halfway through a year, the accrual payment for each year is 0.50s. The expected accrual payment for year 0.5 = 0.0300 x 0.50 s = 0.0150s e( 0.060.50) PV of expected payment at the end of year = 0.0150sx Therefore, PV of expected payments = a + b = 3.2068s + 0.0511s = 3.2579s

Concept checker c. PV of expected pay-off in the event of default

Time (years) Default probability 0.3000 0.0291 0.0282 0.0274 1-Recovery rate 0.70 0.70 0.70 0.70 Expected Payoff ($) 0.0210 0.0204 0.0197 0.0192 Total PV of expected payoff ($) 0.0204 0.0186 0.0170 0.0156 0.0716

0.5 1.5 2.5 3.5

As 3.2579s = 0.0716 i.e., s = 0.0220 or 2.20%. Therefore, mid market spread for the CDS should be 220 bp per year.

Marking the Market of CDS

At inception, the value of CDS is zero i.e., the CDS is priced so that PV of payments made by the buyer of swap is exactly equal to the PV of expected payouts in the event of default (otherwise it will lead to arbitrage opportunities) In the previous example, presume that CDS was originally negotiated 5 years ago at a spread of 175 bp. Calculate the current marked to market value of the CDS for both the buyer and seller. For CDS buyer, M2M value of CDS = PV expected payout recd PV of payments made = 0.0716 (3.2579[0.0175]) = 0.0146 times the NP For CDS seller M2M value of CDS =PV of payments recvd PV of payouts made i.e., -0.0146 times NP i.e., loss. (zero sum game)

CDS Forwards and Options

CDS Forward: It is the obligation to buy or sell a particular CDS on a particular reference entity at a particular future time, T.
Thus a bank could enter into a forward contract to sell 5 year protection on TATA Motors credit for 150 bp starting in 1 year. If Tata Motors defaults during the next year, the banks obligation under forward contract ceases to exist.

CDS Option: It is an option to buy or sell at a particular CDS on a particular reference entity at a particular future time. As in the above referred example, a buyer can buy a call option for buying CDS at 150 bp.
If the 5 year CDS spread for Tata Motors in one year turn out to be more than 150 bp, the option will be exercised. The cost of the option would be paid upfront.

Total Rate of Return (TROR) Swap In a TROR swap, the TROR payer transfers total return (coupons, interest and the gain or loss over the life of the swap) on a risky debt security to the TROR receiver. In turn, TROR receiver pays a return that is typically LIBOR plus some spread. Thus credit risk is transferred from the TROR payer to the TROR receiver.

TROR Swap
Libor + spread

TRS Payer
TROR investment TROR

TRS Receiver

Reference obligation (bond/loan)

TRS Payer

Libor + spread

TRS Receiver

TROR on reference obligation

When payer owns the reference obligation, payer can hedge the credit risk as well as interest rate risk by buying a TROR swap. When the payer does not own the reference obligation, TROR creates a short position for the buyer and a long position for the receiver. While the coupon payments are exchanged periodically like an interest rate swap, the change in the value of the bond either gain or loss is transferred at the end of the swap. If there is default on the bond, the swap is terminated and final payment is made.

Total Return Swap - Example

Exotic Hedge fund will enter into a $100 mn total return swap on the S&P 500 index receiver (i.e., total return receiver). The counterparty (i.e., total return payer) will receive 1 year LIBOR + 400 bp. The contract will last two years and will exchange cash flows annually. Given the following information, determine the cash flows at contract initiation, in one year and two years. Assume LIBOR remains flat.

Current LIBOR = 5% Current S&P 500 value = 1,000 S&P 500 in 1 year = 1,200 S&P 500 in 2 years = 900

Total Return Swap payoff

At the beginning: Similar to other OTC contracts, there will not be any cashflow exchanged in the beginning After 1 year: S&P Index has increased by 20%. Hence Swap receiver will receive $ 20 mn and will pay $ 9 million ( @5% + 400 bp on $100 mn). Therefore, net cashflow will be $11 mn to hedge fund. After 2 years: S&P index dropped by 25% (from 1200 to 900). Therefore swap payer has to pay 25% in addition to 9% floating rate. Hence swap payer i.e., hedge fund will pay $ 34 mn to swap receiver.

TROR Swap Points to remember

TROR creates a long position in the assets for the receiver. Alternative for the receiver would be to buy the bond or the loan itself. However TROR provides the following advantages
Does not require upfront purchase of the asset, resulting in savings on finance costs. Off-balance sheet exposure for the receiver requiring no capital. Hence leveraging is resorted to. It may be more liquid than the underlying asset.

The spread over LIBOR received by the payer is compensation for bearing the risk that the receiver will default. The payer will lose money if the receiver defaults at a time when the reference bonds price has declined. The spread therefore, depends on credit quality of the receiver, the credit quality of the bond issuer and the default correlation between the two.

Credit Spread Options

Credit spread is the difference in the yield between a risky bond and a risk free bond. In Credit Spread Options, the option buyer has the right but not an obligation, to exercise the option when credit spread diverges from a pre-specified strike spread. In a Credit Spread Put Option (CSPO), the put writer makes a payment if the credit spread is greater than the strike spread. In Credit Spread Call Option (CSCO), the option has value when the credit spread is less than the strike spread. The payoffs are as under:

CSPO payoff = NP x duration x max (credit spread strike spread, 0) CSCO payoff = NP x duration x max (strike spread credit spread, 0)

Structured Products

Credit Linked Notes (CLN) and Collaterised Debt Obligations (CDOs)

Credit Linked Note

Protection Buyer
Premium @y

Investor

Certificates @ Libor + x+y

On default, 100% recovery to buyer

Special Vehicle (Trust) Funds its balance sheet by issuing Notes to investors Uses the proceeds to acquire cash collateral (risk free bonds) @Libor +x Sells default protection and passes the yield on the collateral plus the swap premium to investor

If reference credit defaults, cash collateral will be liquidated

In practice, the SPV may retain a small percentage of the coupon to meet the expenses.

Credit Linked Notes

A SPV is set-up to issue notes/certificates The proceeds are invested to acquire cash collateral (risk free bond) equal to the amount of protection sought by the protection buyer. The yield from collateral plus the fees paid for the protection are passed onto the investors If there is default, the cash collateral is liquidated to satisfy the claim of protection buyer and remaining proceeds are distributed to the investors. Thus CLN provides payment that varies with the credit risk of an underlying bond In case there is no default, the collateral is liquidated the satisfy the claims of note holders.

Position of CLN Buyer

CLN allows investors who are otherwise restricted from buying underlying bond/loan/derivative, to invest in synthetic security. Benefits Buyer earns high return if there is no default

Risks
Buyer earns lower return if there is downgrade or default. Buyer has counterparty risk, as CLN issuer may default in their obligation to pay the coupon or par value. The risk is high if there is significant correlation between the CLN issuer and bond issuer. CLNs are often privately traded, illiquid

Collaterised Debt Obligations (CDOs) CDOs are similar to CLNs as in that the issuer transfers a credit risk related return to an investor. Unique features of CDO are
CDO issuer is transferring his exposure to a basket of securities (200 or more) CDOs are typically issued by Special Purpose Vehicle (SPV) or Special Purpose Entitity (SPE). These are trusts set-up by investment banks with a rating of AAA (legally separate from parents) CDOs usually provide tranched returns, with investors choosing tranche that best suits their risk profile.

Cash CDO with N underlying securities

Bond 1

Senior Tranche Residual loss Yield=6%

Average Yield 8.5%

cash Bond 2 return SPV

cash
Mezzanine Tranche nd 25% loss 2 Yield=12%

return

Bond N

Junior tranche Ist 15% loss Yield =20%

At the outset, return is paid at the agreed rate on the principal. However, when there is loss, the return is paid on the remaining principal.

Cash CDO with N underlying securities

SPV has invested in several bonds and then pays the returns to different tranches. There can be a senior tranche, one ore more mezzanine tranches and a junior tranche. Junior most tranche incurs the most credit risk and losses are first assigned to this tranche and are also called equity tranche. They sometimes have threshold where losses are only applied only when the losses exceed threshold. Junior tranche behaves like equity securities and hence expected returns are larger. Sometimes, a portion of junior tranche is retained by the SPV Large part of the CDO is typically the senior tranche carrying an AA or AAA credit rating. Mezzanine tranches, which sustain losses after the junior tranche has absorbed losses, usually have credit ratings of B to AA. The issuer of CDO earns a fee for originating, structuring and managing CDO.

Cash flow Vs Synthetic CDOs

Cash flow CDO: SPV makes an investment in the actual securities that are used to generate payment to the tranches. Synthetic CDO: SPV does not invest in actual securities. Instead the exposure to these securities is created by selling a default swap. (this is similar to synthetic CLN)
Very popular as compared to cash CDOs Off-balance sheet exposure Does not have operational risk with regard to underlying assets

Other variants can be part cash and part synthetic. The CDO could be invested in foreign securities with foreign exchange risk hedged by the SPV with a currency swap.

Synthetic CDO with N underlying securities

Risk free bond CDS Buyer 1
return Payment if default CDS Buyer 2 investment

Senior Tranche

cash SPV Mezzanine Tranche return

Swap premium
CDS buyer N

Junior tranche

Types of CDOs Balance Sheet Vs Arbitrage CDOs (Based on Type)

Primary objective of Balance sheet CDO is to move loans off the balance sheet of commercial banks to lower regulatory capital requirements. Arbitrage CDOs are designed to capture the spread between the portfolio of underlying securities and that of the highly rated tranches. (Senior tranches also seem attractive for investors as they pay relatively higher premium as compared to corporate bonds of corresponding rating too much belief in credit ratings)

Various types of CDOs

Tranched Portfolio Default Swaps Unlike synthetic CDO, the default swap exposure for the SPV is tranched. SPV does not have exposure to Super Senior Tranche. Losses in respect of other tranches are passed onto the investors. Tranched Basket Default Swaps The exposure of an investors tranche is defined by the number of defaults, not the amount. It is a hybrid of Nto-default swap and a CDO Attachment and detachment points as explained in the diagram will govern the exposure CDO squared It is a CDO that invests in other CDOs. Yield is higher than that available from ordinary CDOs. However, CDO2 investments are complicated and difficult to understand

TPDS
Super Senior Tranche
return

Risk free bond

investment

Senior Tranche

Senior Tranche
Mezzanine Tranche

Payment if default

cash SPV Mezzanine Tranche return

Swap premium

Junior Trance

Junior tranche

TBDS
Risk free bond
return Payment if default investment

Senior Tranche 12 to 15

cash SPV Mezzanine Tranche 8 to 11

Basket containing 15 assets

Swap premium

return

The higher the number of the assets and lower the default correlations, the higher the investors risk in respect of Junior tranche.

Junior tranche 1 to 7

CDO squared with Inner CDO and ABS positions

Security 1 Inner CDO Outer CDO

Security 2

CDO tranche A

Security 3

CDO tranche B

CDO2

CDO tranche C
Security 4

ABS

Valuation of a Basket CDS and CDO - Correlation

Suppose a basket of 100 reference entities is used to define a 5-year nth-to-default CDS and that each reference entity has a risk neutral probability of 2% defaulting in 5 years. When the default correlation is zero, the probability of one or more defaults during the 5 years is 86.74% (binomial distribution) and 10 or more defaults is 0.0034%. Therefore, a first-to-default CDS is therefore, quite valuable whereas a tenth-todefault CDS is worth almost nothing. As default correlation increases, the probability of one ore more defaults declines and the probability of 10 or more defaults increases. In an extreme case, where the default correlation is perfect, the probability of one or more defaults equals the ten or more defaults and is 2%. Because in this extreme situation, all the entities are the same and either they all default (2%) or none of them default (98%). The valuation of CDO is similarly dependent on default correlation. If the correlation is low, junior equity tranche is very risky and senior tranches are safe. As the default correlations increase, the junior tranche becomes less risky and senior tranche becomes more risky and when the assets perfectly correlated, all tranches are equally risky.

Gaussian Copula Model to measure the time to default

Because Q1 and Q2 and cumulative probability distributions, the inverse cumulative standard normal function returns variables which are normally distributed: x1 and x2.

Credit Risk of Credit Derivatives

Counterparty Risk
When an institution has transferred credit risk in respect of underlying asset to another institution through derivative, it is exposed to the risk of joint default by the counterparty and the underlying asset. If only one defaults, there is no credit risk The joint probability of default is given by the following equation.

P( AB) Corr ( A, B) P( A)(1 P( A)) P(B)(1 P(B)) P( A) P(B)

Model Risk Legal Risk

Parties may not agree on the terms of trade in case of default, even with full confirmation of the trade (use of ISDA confirmation agreements help resolve some of this uncertainty)

Credit Derivatives Facts to know While banks are net buyers of credit protection, insurers and Hedge funds are net sellers of credit protection. Derivatives like CDS are more liquid than the underlying bonds and provide price discovery. The transaction prices of CDS provide useful information about the cost of credit to outside observers. On the downside, the growth of credit derivatives has created operational risk because of backlogs in the processing of trades. The Lehmans failure (was very active in CDS market) and rescue of AIG (too much exposure to CDS and other derivatives) point to the need to have centralised clearing house to eliminate the counterparty risk.

Thank You !