A Framework for Evaluating Trades in the Credit Derivatives Market

Abstract

Credit default swaps have developed from highly idiosyncratic contracts taking a great deal of time to negotiate into a liquid market offering competitive quotations on single name instruments and even indices of credits worldwide. Synthetic collateralized debt obligations have evolved from vehicles used by commercial banks to offload commercial loan risk to customized tranches where investors can express a view on default correlation as well as credit risk. As a result of these credit instruments, credit trades offered to participants in the credit derivatives market every day involve assessing trade-offs. The authors describe an empirically driven methodology that uses historical default and loss-given-default data to answer questions such as: Is it better to sell credit protection on a single BBB-rated corporate name or on the BBB-rated tranche of a synthetic CDO? Is it better to sell credit protection on a portfolio of BB names or on the equity tranche of a CDO comprised of A-rated names? The methodology presented allows market participants to analyze the risk associated with a single credit, a portfolio of credits, and a tranche of a CDO. It also allows market participants to compare risk to credits with the same underlying rating and to credits with different underlying ratings. The authors demonstrate how the single name, portfolio, and tranched positions would have performed had they been entered into in 1970, 1971, and so on.