Single Name Credit Derivatives

Single Name Credit Derivatives
Paola Mosconi
Banca IMI
Bocconi University, 26/02/2015
Paola Mosconi Lecture 1 1 / 32

Disclaimer
The opinion expressed here are solely those of the author and do not represent in
any way those of her employers

Reference Book
D. Brigo and F. Mercurio

Interest Rate Models Theory and Practice. With Smile, Inflation and Credit
Springer (2006)

Outline
1 Introduction
2 CDS: Stylized Facts
3 Pricing
General Pricing Framework
Model Independent Framework
4 Bootstrapping
General Framework
Constant Intensity
5 Selected References

Introduction
Outline
1 Introduction
3 Pricing
4 Bootstrapping
General Framework
Constant Intensity

Introduction
Credit Derivatives: Basic Concepts
Credit derivatives are bilateral financial contracts that isolate specific aspects of
credit risk from an underlying instrument and transfer that risk between two
parties.
(The J.P. Morgan Guide to Credit Derivatives (1999))
Credit risk is associated with an underlying asset issued by a reference entity (gov-
ernment, financial, corporate) and originates from the inability of the reference
entity to meet its contractual obligations with its counterparties.
A default (or credit) event is determined by the ISDA agreement and typically
includes:
1 bankruptcy,
2 failure to pay,
3 debt restructuring.

Introduction
Single Name Credit Derivatives: a List
Credit Derivatives can be single name or multi-name instruments.
A list of single name credit derivatives includes:

Defaultable zero coupon bonds;
Defaultable coupon bonds;
Defaultable floaters;
Credit Default Swaps (CDS);
Constant Maturity CDS;
Equity payoffs with counterparty risk;
Equity Default Swaps...

Introduction
Credit Default Swaps (CDS)
Credit Default Swaps (CDS) are basic protection contracts that provide the protection
buyer an insurance against the default of a reference entity, in exchange for periodic
payments to the protection seller. They are actively traded and represent a sort of basic
product of the credit derivatives area.
The market for a large number of reference entities is quite liquid and CDS spreads are
determined by supply and demand. There is no need to use pricing models to value CDS
contracts at inception. However, models are necessary in order to:
price more complex credit derivatives, by calibrating models to CDS market quotes
determine the mark-to-market MTM value of existing CDS positions.
Pricing models for default are mainly of two kinds:

1 reduced form (intensity) models
2 structural models

CDS: Stylized Facts
Outline
1 Introduction
3 Pricing
4 Bootstrapping
General Framework
Constant Intensity

CDS: Stylized Facts
CDS: Stylized Facts
A CDS contract ensures protection against default of a reference entity.
The protection buyer A pays to the protection seller B a given rate R, at times Ta+1 , . . . , Tb
or until default (the premium leg), in exchange for a single protection payment1 LGD (the
protection leg) at default time of a reference entity C, provided that Ta < Tb .
Schematically:
Protection protection LGD at default if Ta < Tb Protection

Seller B rate R at Ta+1 , . . . , Tb or until default Buyer A
At evaluation time t, the amount R is set at a value Rab (t) that makes the contract fair,
i.e. such that the present value of the two exchanged flows is zero. This is how the market
quotes CDS
1 LGD = Loss Given Default

CDS: Stylized Facts
Assumptions and Notations
Let us denote:
the year fraction between two consecutive dates as i Ti Ti 1
the first date among the {Ti }i =a+1,...,b following t as T(t) , i.e.
t [T(t)1 , T(t) )
the stochastic discount factor as D(t, T ) = B(t)/B(T ), where
Rt
ru du
B(t) = e 0
represents the bank account numeraire, r being the instantaneous short

interest rate.
Let us assume
the Loss Given Default LGD 1 Recovery Rate to be deterministic
the default time and the interest rate process r to be independent
unit notional amount.

CDS: Stylized Facts
Cash Flows
Premium Leg payments
The premium leg pays
at each time Ti , if default has not occurred yet, the periodic fee: R i 1{ Ti }
at default time , if < Tb , the accrued interest: R ( T( )1) 1{Ta < <Tb }
where 1{X } is the indicator function of set X .
Protection Leg payments

The protection leg pays
at default time , if Tb , the Loss Given Default: LGD 1{ <Tb }
Discounted payoff seen from B

CDSab (t) = PremLab (t) ProtLab (t) (1)
b
X
= D(t, )( T( )1 )R 1{Ta < <Tb } + D(t, Ti )i R 1{ Ti }
i =a+1
D(t, )LGD 1{Ta < Tb }

Pricing
Outline
1 Introduction
3 Pricing
4 Bootstrapping
General Framework
Constant Intensity

Pricing General Pricing Framework
Let use denote by CDSa,b (t, R, LGD) the price at time t of the CDS.
At t = 0, the price is given by the expectation of the discounted payoff CDSab (0)
under the risk neutral measure Q:
CDSa,b (0, R, LGD) = E[CDSab (0)] . (2)
This is equivalent to pricing (analytically) both legs.

Pricing General Pricing Framework
Goal
In general, the resulting pricing formulas depend on the choice of the underlying
model (intensity based or structural) used to describe the dynamics of:
the default event
interest rates
the loss given default2 .
However, such formulas will not be used to price CDS that are already quoted in
the market.
Rather, they will be inverted in correspondence of CDS market quotes to
calibrate the models to the CDS quotes themselves.
2 LGD is assumed to be constant and given by historical estimates of rating agencies.

Pricing Model Independent Framework
Before tackling the general problem of deriving pricing formulas for CDS under
specific model assumptions, which will be dealt with in Lectures 2 and 3, we show
how to derive model independent formulas, given, at time t = 0:
the initial zero coupon curve (bonds) observed in the market: P mkt (0, Ti )
the survival probabilities.

Survival Function (Li 2000)...
Let F (t) denote the distribution function of default time :
F (t) := Pr( t) t 0 and F (0) = 0.
If F is differentiable, its derivative f represents the density function and:

Z t
F (t) = f (u)du .

The probability that default does not occur before time t represents the
survival probability and is described the survival function S(t):
Z
S(t) := Pr( t) = f (u)du = 1 F (t) .
t

Premium Leg I
Under independence between default and interest rates, the expected value of the pre-
mium leg, under the risk neutral measure Q, is given by:

b
X
PremLab (R) = E D(0, )( T( )1 )R 1{Ta < <Tb } + D(0, Ti )i R 1{ Ti }
i =a+1
Z b
X
=E D(0, t)(t T(t)1 )R 1{Ta <t<Tb } 1{ [t,t+dt)} + E[D(0, Ti )]i R E[1{ Ti } ]
0 i =a+1
Z Tb b
X
=E D(0, t)(t T(t)1 )R 1{ [t,t+dt)} + P(0, Ti )i R Q( Ti )
Ta i =a+1
Z Tb b
X
= E[D(0, t)](t T(t)1 )R E[1{ [t,t+dt)} ] + R P(0, Ti )i Q( Ti )
Ta i =a+1
Z Tb b
X
= P(0, t)(t T(t)1 )R Q( [t, t + dt)) + R P(0, Ti )i Q( Ti )
Ta i =a+1

Premium Leg II
Given that dt is infinitesimal, it follows
Q( [t, t + dt)) = Q( < t + dt) Q( < t)

= dQ( < t)
= d[1 Q( t)]
= dQ( t)
and
" Z b
#
Tb X
PremLab (R) = R P(0, t)(t T(t)1 ) dQ( t) + P(0, Ti )i Q( Ti )
Ta i =a+1

Protection Leg
Under independence between default and interest rates, the expected value of the pro-
tection leg, under the risk neutral measure Q, is given by:

ProtLab = E LGD D(0, ) 1{Ta < Tb }
Z
= LGD E D(0, t) 1{Ta < Tb } 1{ [t,t+dt)}
0
Z Tb
= LGD E[D(0, t) 1{ [t,t+dt)}]
Ta
Z Tb
= LGD E[D(0, t)] E[1{ [t,t+dt)}]
Ta
Z Tb
= LGD P(0, t) Q( [t, t + dt))
Ta
and
Z Tb
ProtLab = LGD P(0, t) dQ( t)
Ta

CDS Model Independent Pricing Formula
The CDS price at time t = 0 is given by:
CDSab (0, R, LGD; Q( > )) = PremLab (Q( > )) ProtLab (Q( > ))
" Z b
#
Tb X
=R P(0, t)(t T(u)1 ) dQ( t) + P(0, Ti )i Q( Ti )
Ta i =a+1
Z Tb
LGD P(0, t) dQ( t)
Ta
The integrals in the survival probabilities can be approximated numerically by sum-

mations through Riemann-Stieltjes sums, considering a low enough discretization
time step.

CDS Market Quotes
The market quotes, at time 0, the fair CDS rate

mkt MID
R = R0,b (0)
with initial protection time

Ta = 0
and final protection time
Tb {1y , 3y , 5y , 7y , 10y } .

CDS Rates
mkt MID
R0,b (0) is obtained by solving:
mkt MID
CDSab (0, R0,b (0), LGD; Q( > )) = 0
which gives:
R Tb
mkt MID LGD P(0, t) dQ( t)
0
R0,b (0) = R T
P(0, t)(t T(t)1 ) dQ( t) bi=1 P(0, Ti )i Q( Ti )
b
P
0
Using the initial zero coupon curve (bonds) observed in the market, P mkt (0, Ti ), and the
mkt MID
market quotes of R0,b (0), starting from Tb = 1y , we can find the market implied
survival {Q( t), t 1y } and iteratively bootstrap all the survival probabilities
{Q( t), t (1y , 3y ]} and so on up to Tb = 10y .
This is a way to strip survival probabilities from CDS quotes in a model independent
way, with no need to assume an intensity or structural model of default!
However, the market in doing the above stripping typically resorts to hazard functions
associated with the default time.
...Hazard Functions (Li 2000)

Recalling the survival function introduced above, survival probabilities can be equivalently
expressed in terms of the so-called hazard functions.
The default rate at time t, conditional on survival until time t or later, defines the
hazard rate function:
Pr(t < t + dt) F (t + dt) F (t) f (t) S (t)
h(t) := lim = = = (3)
dt0 dt Pr( t) dt S(t) S(t) S(t)
The cumulative hazard function H(t) is defined as:

Z t Z t
H(t) := h(u)du = d(ln S(u)) = ln S(t) (4)
0 0
Then, the survival function S(t), describing the survival probability up to time t,
can be expressed in terms of hazard functions as:
Rt
S(t) = e 0
h(u)du
= e H(t)

Bootstrapping
Outline
1 Introduction
3 Pricing
4 Bootstrapping
General Framework
Constant Intensity

Bootstrapping General Framework
General Framework
GOAL: Quoted spread survival probabilities intensity
Assume the existence of a deterministic default intensity (t), such that (t) dt repre-
sents the probability rate of defaulting in [t, t + dt) having not defaulted before t:
Q( [t, t + dt)| > t) = (t)dt .
Recalling definitions (3) and (4) of hazard functions, the cumulated intensity is nothing
but a cumulated hazard rate: Z t
(t) := (t) dt .
0
The survival probability (under the risk neutral measure) can be written as
Q( t) = e (t) . (5)
Also,
dQ( t) = (t) e (t) dt .
Bootstrapping General Framework
Interest Rate Analogy
Usually, the actual model assumes for the default time a more complex structure (e.g.
stochastic intensity). However, mkt are retained as a mere quoting mechanism for CDS
rate market quotes.
If the intensity is stochastic ((t)) the survival probability formula (5) must be generalized
as follows: h Rt i
Q( t) = E e 0 (u)du .
This is just the price of a zero coupon bond in an interest rate model with short rate r
replaced by . In this way, survival probabilities can be interpreted as zero coupon
bonds and intensity (or in the deterministic case) as instantaneous credit spreads.
In the following, we will show a very simple quoting mechanism, based on constant in-
tensity. Further examples, based on deterministic and stochastic intensities, will be dealt
with extensively, when considering Reduced Form (Intensity) Models (see Lecture 2).

Bootstrapping Constant Intensity
Constant Intensity Formula
The market makes intensive use of a simple formula for calibrating a constant
intensity (hazard rate) (t) = to a single CDS rate, R0,b :
R0,b
= .
LGD
Since can be interpreted as an instantaneous credit spread, this interpretation

can be extended to R as well. Therefore, the CDS premium rate R admits a
double interpretation, either as a credit spread or as a default probability.
This formula is handy, since it does not require the interest rate curve. However,
it does not take into account the term structure of CDS, being based on a single
quote for R. It can be used in any situation where one needs a quick calibration
of the default intensity to a single CDS quote (e.g. the liquid 5y one).

Constant Intensity: Formula Derivation I
Assumptions
independence between default time and interest rates
the premium leg pays continuously until default the premium rate R of the
CDS: i.e. in the interval [t, t + dt) the premium leg pays R dt.
Premium Leg
Z T Z T
PremL = E D(0, t) 1{ >t} R dt = R E[D(0, t) 1{ >t} ] dt
0 0
Z T Z T
=R E[D(0, t)] E[1{ >t} ] dt = R P(0, t) Q( > t) dt
0 0

Constant Intensity: Formula Derivation II

Protection Leg

Z T
ProtL = E LGD D(0, t) 1{ T } = LGD E D(0, t) 1{ [t,t+dt)}
0
Z T Z T
= LGD P(0, t) Q( [t, t + dt)) = LGD P(0, t) dQ( > t)
0 0
Given the constant intensity assumption, i.e.
Q( > t) = e t and dQ( > t) = e t dt = Q( > t)dt
it follows: Z T
ProtL = LGD P(0, t) Q( > t)dt .
0
Premium Leg = Protection Leg

Z T Z T
R
R P(0, t) Q( > t) dt = LGD P(0, t) Q( > t)dt =
0 0 LGD

Selected References
Outline
1 Introduction
3 Pricing
4 Bootstrapping
General Framework
Constant Intensity

Selected References
Selected References
The J.P. Morgan Guide to Credit Derivatives (1999)

http://www.investinginbonds.com/assets/files/Intro to Credit Derivatives.pdf
Li, D. X., (2000), On Default Correlation: A Copula Approach, Journal of Fixed
Income, 9

Single Name Credit Derivatives

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Bocconi University, 26/02/2015

Paola Mosconi Lecture 1 1 / 32

Paola Mosconi Lecture 1 2 / 32

D. Brigo and F. Mercurio

Paola Mosconi Lecture 1 3 / 32

2 CDS: Stylized Facts

Paola Mosconi Lecture 1 4 / 32

2 CDS: Stylized Facts

Paola Mosconi Lecture 1 5 / 32

Credit Derivatives: Basic Concepts

Paola Mosconi Lecture 1 6 / 32