Credit Derivatives Handbook: Global Perspectives, Innovations, and Market Drivers

Advance Praise for The Credit Derivatives Handbook

This handbook on the rapidly developing and important market segment represented by credit derivatives will be useful to anyone requiring a comprehensive review and introduction to most aspects of this exciting new area, including innovations, design, pricing, and asset allocation. The editors are to be congratulated on this timely and valuable set of contributions featuring this important new class of financial instruments.

—David E. Allen, Professor of Finance, Edith Cowan University, Perth, Western Australia

"The Handbook of Credit Derivatives presents a rigorous examination of the design, pricing, and use of credit derivatives. It combines an impressive breadth of topics with in-depth analysis of individual topics. The result is a relevant and reliable source of information about credit derivatives for both investors and researchers."

—Paul Brockman, Matteson Professor of Financial Services, Department of Finance, University of Missouri-Columbia, Columbia, Missouri

An impressive survey of current research in credit derivatives by academics and practitioners from around the world. It will be useful to those working outside the area who wish to gain a greater understanding of this topic and to those within the field who want to learn more about state-of-the-art research in credit derivatives.

—Burt Porter, Iowa State University, Ames, Iowa

The book is an interesting compilation of several relevant themes in credit risk that range from CDS pricing and innovations to CDO pricing and their role in investment portfolios. Paul Ali and Greg Gregoriou have struck well the delicate balance between theoretical and empirical papers and also managed to include geographies beyond the United States.

—Dr. Viral Acharya, Professor of Finance and Academic Director of Private Equity Institute, London Business School, London

THE CREDIT DERIVATIVES HANDBOOK

THE CREDIT DERIVATIVES HANDBOOK

Global Perspectives, Innovations, and Market Drivers

GREG N. GREGORIOU

PAUL U. ALI

EDITORS

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

ISBN: 978-0-07-154953-0

MHID: 0-07-154953-6

The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-154952-3, MHID: 0-07-154952-8.

All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps.

McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please e-mail us at bulksales@mcgraw-hill.com.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, futures/securities trading, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

—From a Declaration of Principles jointly adopted by a Committee

of the American Bar Association and a Committee of Publishers

TERMS OF USE

This is a copyrighted work and The McGraw-Hill Companies, Inc. (McGraw-Hill) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms.

THE WORK IS PROVIDED AS IS. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.

CONTENTS

ACKNOWLEDGMENTS

EDITORS

CONTRIBUTORS

INTRODUCTION

Paul U. Ali and Greg N. Gregoriou

PART ONE

INNOVATIONS IN CREDIT DEFAULT SWAPS

Chapter 1

The Changing Face of Credit Default Swaps

Paul U. Ali and Jan Job de Vries Robbé

Introduction

Credit Default Swaps

References

Chapter 2

Derivatives in Islamic Finance

Andreas A. Jobst

Introduction

Types of Islamic Finance

Implicit Derivatives: Identification and Evaluation

Islamic Finance and Structured Finance

Explicit Derivatives in Islamic Structured Finance: Credit Risk Transfer

Assessment of Derivatives in Islamic Finance

Conclusion: The Prospects of Islamic Derivatives

Acknowledgments

References

Chapter 3

Credit Derivatives and the Resolution of Financial Distress

Stephen J. Lubben

Introduction

Chapter 11 Today

Credit Derivatives and the Prebankruptcy Period

Credit Derivatives in Chapter 11

Conclusion

References

Chapter 4

Asymmetric Information and Opacity in Credit Derivatives Markets

Antonio Nicolò and Loriana Pelizzon

Introduction

Related Literature

The Model

Asymmetric Information

A Simple Model with Moral Hazard and Adverse Selection

Conclusion

Appendix

References

Chapter 5

The Role of Macro and Country-Specific Factors on the Use of Credit Derivatives: Sovereign Credit Default Swap Market

Mehmet Orhan and M. Nihat Solakoglu

Introduction

Credit Derivatives: A Brief Overview

An Emerging Market Overview: Turkey

Data and Methodology

Estimation Results

Conclusion

References

PART TWO

PRICING CREDIT DEFAULT SWAPS

Chapter 6

Pricing Credit Derivatives with a Copula-Based Actuarial Model for Credit Risk

Giovanni Masala, Massimiliano Menzietti, and Marco Micocci

Introduction

The Model for Default and Credit Migration

Credit Derivatives

Conclusion

References

Chapter 7

Asset Dynamics Estimation and Its Impact on CDS Pricing

Pascal François and Georges Hübner

Introduction

No-Arbitrage Pricing of CDS

The Structural Model of Credit Risk

Estimation of Asset Value Dynamics

Empirical Impact

Analysis of the Pricing Error

Conclusion

References

Chapter 8

A Unified Approach to the Theory of Default Risk and Credit Derivatives

François-Éric Racicot and Raymond Théoret

Introduction

A Simple Model of Credit Risk

Normal Events and Rare Events

The Poisson Distribution

Credit Risk in the Framework of the B&S Differential Equation

The Merton Model and its Extensions

Dynamic Modeling of the Probability of Default: The Probabilities of Transition

Credit Derivatives

Other Approaches to Credit Risk

Conclusion

References

Chapter 9

Investigating the Link between Credit Default Swap Spreads and the U.S. Financial Market

Hayette Gatfaoui

Introduction

Data Set

Econometric Study

Investigating a Joint Evolution

Linear Framework

Conclusion

References

PART THREE

DESIGN AND PRICING OF COLLATERALIZED DEBT OBLIGATIONS

Chapter 10

Design of Collateralized Debt Obligations: The Impact of Target Ratings on the First Loss Piece

Marc Gürtler, Martin Hibbeln, and Sven Olboeter

Introduction

Collateralized Debt Obligations

Information Asymmetries in CDO Transactions

Portfolio Construction and the Size of the First Loss Piece

Conclusion

References

Chapter 11

On the Pricing of Collateralized Debt Obligations

Raquel M. Gaspar and Thorsten Schmidt

Introduction

Portfolio Credit Derivatives

Model and Applications

Conclusion

Appendix

References

Chapter 12

Pricing Forward-Starting Collateralized Debt Obligations Using Dynamic Copula Processes

Daniel Totouom and Margaret Armstrong

Introduction

Archimedean Copulas within the Credit Framework

Dynamic Copulas from a Levy Process Perspective

Dynamic Copulas Based on Gamma-OU Process

Comparing the Two Dynamic Copula Models

Conclusion

Appendix 1

Appendix 2: Simulating the Gamma-OU Process

References

Chapter 13

Identifying Systemic and Idiosyncratic Risk from Standardized Single-Tranche Collateralized Debt Obligations

Jorge A. Chan-Lau and Yinqiu Lu

Introduction

A Brief Primer on CDOs

Default Probability and Default Correlation in STCDOs

Idiosyncratic and Systemic Risk in STCDO Tranches

Data and Empirical Framework

Results

Conclusion

References

Chapter 14

Default Contagion in Large Homogeneous Portfolios

Alexander Herbertsson

Introduction

Intensity-Based Models in a Homogeneous Model Reinterpreted as Markov Jump Processes

Using the Matrix-Analytic Approach to Find Multivariate Default Distributions and Related Quantities

Calibrating the Model Parameters against CDO Tranche Spreads, Index CDS Spreads, and Average CDS Spreads

Numerical Studies

Conclusion

Acknowledgments

References

PART FOUR

ASSET ALLOCATION AND CREDIT DERIVATIVES

Chapter 15

An Asset Allocation Problem with Credit Derivatives

Francesco Menoncin

Introduction

The Model

The Optimal Portfolio

Conclusion

Appendix

References

Chapter 16

Synthetic Collateralized-Debt-Obligation-Squared Pricing Methodologies

Dominique Guégan and Julien P. Houdain

Introduction

Synthetic CDO-Squared Structures

Synthetic CDO-Squared Pricing

Conclusion

References

Chapter 17

The Role of Credit and Credit Index Derivatives in Portfolio Management: Asset Allocation Issues and Opportunities

R. McFall Lamm, Jr.

Introduction

Credit Market Performance

The Role of Riskier Credit in Investment Portfolios

Using Index Derivatives to Alter Portfolio Asymmetry Properties

Allocation via Active Rules

Conclusion

References

INDEX

ACKNOWLEDGMENTS

We would like to thank a handful of anonymous referees for reviewing and selecting the chapters for this book. We also thank Jeanne Glasser and the team at McGraw-Hill as well as Richard Rothschild and the production team at Print Matters. Each of the chapters in this book is the original work of the relevant author(s). We thank them for their contribution. Neither the editors nor the publisher can guarantee the accuracy of the chapters.

EDITORS

Greg N. Gregoriou is Professor of Finance in the School of Business and Economics at State University of New York (Plattsburgh). A native of Montreal Greg received his Bachelor of Arts in Economics from Concordia University in 1988. In 1991 he completed his MBA from the University of Quebec at Montreal (UQAM) and obtained his Graduate Diploma in Applied Management from McGill University. He then completed his PhD in finance at UQAM in the joint doctoral PhD program in Montreal (McGill University, Concordia, and HEC Montreal). He specializes in hedge funds, funds of hedge funds, and managed futures. He has published over 50 academic articles on hedge funds and managed futures in various peer-reviewed journals, such as the Journal of Portfolio Management, Journal of Futures Markets, European Journal of Operational Research, Annals of Operations Research, Computers and Operations Research INFORS, Journal of Asset Management, Journal of Alternative Investments, European Journal of Finance, Journal of Derivatives Accounting, Journal of Financial Crime, and Journal of Wealth Management and has written 20 book chapters. He is hedge fund editor and editorial board member for Journal of Derivatives and Hedge Funds, a London-based academic journal, and also editorial board member of the Journal of Wealth Management and the Journal of Risk and Financial Institutions. He is the co-author and co-editor of 24 books published by John Wiley & Sons, Elsevier Butterworth-Heinemann, McGraw-Hill, Palgrave-MacMillan, and Risk Books.

Paul U. Ali is an Associate Professor in the Faculty of Law, University of Melbourne, and a member of that Law Faculty’s Centre for Corporate Law and Securities Regulation. Prior to becoming an academic, Paul was, for several years, a finance lawyer in Sydney. Paul has published widely on banking and finance law, corporate governance and institutional investment law, securitization law, and structured finance law. His most recent publications include Innovations in Securitization (The Hague, 2006), International Corporate Governance after Sarbanes-Oxley (Hoboken, NJ, 2006), Opportunities in Credit Derivatives and Synthetic Securitization (London, 2005), and Securitization of Derivatives and Alternative Asset Classes (The Hague, 2005). In 2006 the Australian Federal Attorney General appointed Paul a member of the Personal Property Securities Review Consultative Group. Paul holds a S.J.D. from the University of Sydney.

CONTRIBUTORS

Margaret Armstrong has a Masters degree in mathematical statistics at the University of Queensland (Australia). Margaret moved to France where she received a doctorate in geostatistics (stochastic processes applied to natural resources) in 1980. Her research interests include financial analysis of mining and petroleum projects as well 3-dimensional (3D) spatial modeling. In 2001 she and Alain Galli started the quantitative finance group within the Ecole des Mines de Paris. Their research topics include commodities, real options and credit derivatives.

Jorge A. Chan-Lau is a senior economist in the Monetary and Capital Markets Department at the International Monetary Fund. He holds M.Phil. and PhD degrees in Economics and Finance from the Graduate School of Business, Columbia University, and a BS in Civil Engineering from Pontificia Universidad Catolica del Peru. He currently works on credit risk, financial markets, and financial stability and has published work on contagion, financial crises, credit derivatives, corporate restructuring, risk management, and institutional investors’ asset allocation.

Jan Job de Vries Robbé is structured finance counsel at FMO, the Dutch Development Bank. He specializes in securitization and derivatives. He has extensive experience in structured finance, gained both in private practice (at De Brauw Blackstone Westbroek and Minter Ellison) and in-house (at NIBC and ANZ) in Europe and overseas. He regularly lectures on structured finance and is a visiting scholar at the University of Melbourne, where he lectures on securitization and derivatives. He has authored and edited various books on structured finance, including Synthetic, Insurance and Hedge Fund Securitization (2003), Opportunities in Credit Derivatives and Synthetic Securitization (2005), Securitization of Derivatives and Alternative Asset Classes (2005), and Innovations in Securitization (2006).

Pascal François is Associate Professor at HEC Montreal’s Department of Finance. He holds a PhD from Sorbonne University and ESSEC Business School. He is a member of the CREF scientific committee (Research Centre in E-Finance) based in Montreal. His research focuses on the pricing and the design of debt contracts, with a special emphasis on credit risk, capital structure, and corporate debt financing strategies. His publications appeared in the Journal of Business, the Journal of Banking and Finance, the Financial Review, and the European Journal of Operational Research. His book on derivatives (Dunod editions, 2005) was recently awarded the François-Albert Angers Prize.

Raquel M. Gaspar is assistant professor at ISEG, Technical University of Lisbon, since February 2006. She has a PhD in Finance from the Stockholm School of Economics (SSE); post-graduate studies in Risk Management and Derivatives from IDEFE, NOVAFORUM, and Instituto de Mercados de Capitais (IMC); a Masters in Applied Mathematics from ISEG; and undergraduate studies in Economics from Universidade Nova de Lisboa. Her research interests are in mathematical finance and concretely in credit risk, energy markets, portfolio optimization, and term structure models.

Hayette Gatfaoui obtained his PhD in 2002 at the University of Paris 1 Sorbonne. His PhD dissertation dealt with credit risk valuation in corporate bonds. Hayette is an associate professor at Rouen School of Management where he teaches fixed income, applied stock portfolio management, financial markets, financial mathematics as well as stochastic calculus, and quantitative method courses to postgraduate students. His main research areas are credit risk assessment, risk management, and modeling. He also does consulting in the portfolio performance measurement area for numerous financial firms and is also a member of the editorial board of the Middle Eastern Finance and Economics Journal.

Dominique Guégan is Full Professor in Mathematics in University Paris1—Panthéon—Sorbonne. She obtained her PhD (in Mathematics) in 1975 from the University of Grenoble (France). She has published seven books on mathematics, nonlinear time series, and chaos theory. She has also published over 55 articles in finance, probability, statistics, nonlinear time series, econometrics, and chaos theory, including the Statistics and Probability Letters, Economic Letters, Econometrics Review, Journal of Statistical and Planning Inference, and the Journal of Applied Probability. She has also contributed numerous book chapters for 10 edited books.

Marc Gürtler is Professor of Finance at the Technical University at Braunschweig. Before coming to Braunschweig in 2002, he was assistant professor of Finance at RWTH Aachen University. His fields of research interest are credit risk management, portfolio management, and international financial management.

Alexander Herbertsson is at present employed as researcher at Centre for Finance and Department of Economics at the School of Business, Economics and Law, belonging to Göteborg University. He holds a PhD in Economics from Göteborg University and has a Licentiate degree in industrial mathematics from Chalmers University of Technology and an MS in Engineering Physics from the same university. His main research field is default dependence modeling with a view towards pricing and hedging portfolio credit derivatives. Alexander has also done practical work in option pricing (implied volatility tree models) as a programmer and quantitative analyst in the Financial Engineering and Risk Management group at Handelsbanken Markets, Stockholm. He has taught mathematics courses at Chalmers University of Technology, in stochastic calculus for PhD students at the Department of Economics and also supervised several MS theses in Financial Mathematics.

Martin Hibbeln is research associate at the chair of Finance (since 2004), Technical University at Braunschweig. His fields of research interest are financial intermediation and credit risk management, the latter particularly with regard to concentration risk in credit portfolios. Furthermore, he works at the Volkswagen Bank GmbH on LGD modeling.

Julien P. Houdain is a Structured Credit Fund Manager at Legal & General IM. Before that he was a Structured Finance Quantitative Strategist at Fortis Investments, Paris. He had a very active participation to the pricing and the management of more than 30 bespoke CDO deals (Synthetic CDO, First to Default CDO, Single Tranche CDO, CDO Squared, CDO of ABS, CPPI with CDO Tranches and CDS Indexes). He developed market standard and proprietary models for the pricing of all types of CDO structures. He has also worked on trading long and short hedging strategies for CDO tranches, single-name CDS, and CDS indexes. He has published several internal articles on CDO pricing and hedging and made numerous presentations for clients, investors, and counter parties. He obtained his PhD (Business and Economics) from the École Normale Supérieure at Cachan-France in 2006.

Georges Hübner (PhD, INSEAD) is the Deloitte Professor of Financial Management and is cochair of the Finance Department at HEC—Management School of the University of Liège. He is Associate Professor of Finance at Maastricht University and Academic Expert at the Luxembourg School of Finance, University of Luxembourg. He is also an Affiliate Professor at EDHEC (Lille/Nice) and an Invited Professor at the Solvay Business School (Brussels). He has published numerous research articles in leading scientific journals including Journal of Banking and Finance, Journal of Empirical Finance, Review of Finance, Financial Management, and Journal of Portfolio Management. Georges Hübner was the recipient of the prestigious 2002 Iddo Sarnat Award for the best paper published in the Journal of Banking and Finance in 2001, and corecipient of the Operational Risk & Compliance Achievement Award 2006 in the best academic paper category.

Andreas Jobst is a mid-career economist at the Monetary and Capital Markets Department (MCM) of the International Monetary Fund (IMF) in Washington, DC. His research focuses on structured finance, risk management, sovereign debt management, financial regulation, and time series econometrics. He previously worked at the Division for Insurance and Research at the Federal Deposit Insurance Corporation (FDIC), the Economics Department of the Deutsche Bundesbank, the Financial Markets Group (FMG) at the London School of Economics (LSE), the Center for Financial Studies (CFS) in Frankfurt/Main, the International Division of the European Central Bank (ECB), the Financial Institutions Division of the Bank of England, the Comisión Económica para América Latina y el Caribe (CEPAL) of the United Nations, the European Securitization Group of Deutsche Bank in London, and the Financial Services Group of the Boston Consulting Group (BCG). Mr. Jobst holds a PhD in Finance from the London School of Economics (LSE). He was also educated in Oxford, Cambridge, Leicester and Maryland, and holds the professional qualification of Accredited Asset Management Specialist (AAMS). Andy is a regular speaker at professional and academic conferences on risk management and structured finance. His most recent research was published in Derivatives Use, Trading & Regulation, Managerial Finance, International Journal of Emerging Markets, Journal of Banking Regulation, Journal of Structured Finance, International Journal of Banking Law and Regulation, Journal of Operational Risk, Macroeconomics and Finance in Emerging Market Economies, The Securitization Conduit, and Euromoney. He has also been one of the authors of the Global Financial Stability Report published by the Monetary and Capital Markets Department of the IMF (2005–2007).

Yinqiu Lu is an economist in the Monetary and Capital Markets Department at the International Monetary Fund. She holds a PhD in Economics from the City University of New York, an MA in economics from Fudan University, China, and a BA from Nanjing University, China. She currently works on credit derivatives, structured products, and sovereign asset and liability management.

Stephen J. Lubben is the Daniel J. Moore Professor of Law at Seton Hall University School of Law, in Newark, NJ, where he specializes in corporate reorganization. Professor Lubben joined Seton Hall after several years in practice with Skadden, Arps, Slate, Meagher & Flom in New York and Los Angeles, where he represented parties in chapter 11 cases throughout the United States.

Giovanni Masala is a researcher in mathematical methods for economy and finance at the Faculty of Economics in the University of Cagliari (Italy). He obtained his PhD in differential geometry from the University of Mulhouse (France) and his current research interests include mathematical risk modeling for financial and actuarial applications.

R. McFall Lamm, Jr. is the chief investment strategist for Deutsche Bank’s Global Investment Management Group in London. His current responsibilities include asset allocation for DB’s discretionary management business, advising large bank clients on portfolio strategy, and directly managing a boutique hedge fund portfolio. Dr. Lamm is a frequent speaker at conferences and events around the globe. He also writes market commentary that is disseminated worldwide and is often quoted in the news media. In addition, Dr. Lamm is an energetic writer having published numerous book chapters and professional articles in publications such as the The Journal of Portfolio Management, The Journal of Economic Dynamics and Control, and The Journal of Alternative Investments.

Francesco Menoncin is Associate Professor at Brescia University (Italy). He obtained his MA and PhD in Economics at Louvain-Le-Neuve (Belgium). His fields of interests are stochastic programming, optimal portfolio rules, pension funds, and, in general, the link between actuarial and financial risks. He has published numerous papers in Insurance: Mathematics and Economics, Annals of Operations Research, European Journal of Finance, Revue Economique, and International Economics.

Massimiliano Menzietti is Professor of Life Insurance Mathematics in the University of Calabria (Cosenza). From 2002 to 2006 he was research fellow of the Department of Actuarial and Financial Science in the University La Sapienza of Rome. He graduated in economics from the University LUISS-Guido Carli of Rome. He obtained a PhD in Actuarial Science from University La Sapienza of Rome. His research has focused on actuarial mathematics of pension schemes, financial mathematics (specifically on actuarial model for credit risk), and automobile car insurance. He is now also working on actuarial mathematics and risk management of long term care insurance.

Marco Micocci is full Professor of Financial Mathematics and Actuarial Science at the University of Cagliari. From 1996 to 2001 he was Researcher of Financial and Actuarial mathematics at the University of Rome La Sapienza. He has a degree in economics, a degree in banking, financial, and insurance science, and a degree in actuarial statistics. His fields of research are financial and actuarial management of pension funds, mathematical finance, and credit risk. He is author of over 60 publications (papers, articles, books) and is also a consultant actuary.

Antonio Nicolò, PhD, Universitat Autonoma de Barcelona, is currently Associate Professor at the University of Padua (Italy). His main research interests are in theoretical economics, namely, game theory, contract theory, and social choice. He was awarded in 2005 the Financial Management Association (FMA) European Conference Best Paper Award, for the paper Credit Derivatives: Capital Requirements and Strategic Contracting (with L. Pelizzon). In 2004 he won the M. Fanno Prize for young researchers of the M. Fanno Department of Economics (University of Padua). He is local organizer and Chair of the Scientific Committee of the 2007 Association of Southern European Economist Theorists (ASSET) meeting at Padua (Italy). His work includes papers published in the Journal of Economic Theory, Games and Economic Behavior, Journal of Public Economic Theory Mathematical Social Sciences, and Review on Economic Design. During the last few years, he visited the Indian Statistical Institute, New Delhi Centre (2007), the Department of Economics, University of Rochester (2006), and the Center for Mathematical Studies in Economics & Mathematical Science, Kellogg’s School of Management, Northwestern University (2005).

Sven Olboeter is a research associate at the chair of Finance (since 2006), Technical University at Braunschweig. His field of research interest is credit risk management particularly with regard to credit derivatives. Sven also works at the Volkswagen Bank GmbH on LGD modeling.

Mehmet Orhan is associate professor at the Economics Department of Fatih University, Istanbul. He is also the Director of Social Sciences Institute that is responsible from the coordination of several graduate programs. He has MA and PhD degrees from Bilkent University, Ankara, and has graduated from the Industrial Engineering Department of the same university. His main interest is econometrics, both theoretical and applied and has published numerous articles in Economics Letters, International Journal of Business, and Journal of Economic and Social Research. His theoretical research interests include HCCME estimation, robust estimation techniques, and Bayesian inference. His areas of interest are IPO performance in Turkey, hedge funds, venture capital, inflation and its uncertainty, tax revenue estimation, and international economic cooperation.

Loriana Pelizzon is Associate Professor of Economics at the University of Venice. She graduated from the London Business School with a doctorate in Finance. She also holds a degree from the University of Venice (Laurea in Business Administration). She was assistant professor in Economics at the University of Padova from 2000 until 2004. Her research interests are risk measurement and management, asset allocation and household portfolios, hedge funds, financial institutions, and financial crisis. Her work includes papers published in the Journal of Financial and Quantitative Analysis, European Journal of Finance, Journal of Economics and Business, and Journal of Empirical Finance, and she has presented at the Western Finance Association and European Finance Association. Pelizzon has been awarded the EFA 2005 Barclays Global Investor Award for the Best Symposium paper and FMA European Conference, 2005 best conference paper. She is participating in many research projects: NBER, FDIC, RTN, HCM, TACIS, ACE, MURST, PRIN, etc. She is a referee for the following journals: JMCB, JFI, JEFM, JMFM, JB&F, RoF, JIFMIM, Journal of Macroeconomics, Risk Analysis, Research in Economics, RISEC, and Elsevier: Finance Publications. In addition, she is a member of the Program Committee: European Finance Association Conferences, Coordinator of the EFA Doctoral Tutorial, and Member of the Teaching Committee of the PhD in Economics, University of Venice. She teaches financial economics and investments at the International Master in Economics and Finance Program and economics and financial economics at the undergraduate program. She has been awarded the Best Teacher 2006 at the Ca’ Foscari University of Venice. She frequently advises banks and government agencies on risk measurement and risk management strategies.

François-Éric Racicot, PhD, holds a joint doctorate in Business Administration (Finance) from UQAM. He also holds an MS in Economics (Econometrics) from University of Montreal where he also received his BS in Economics (Quantitative Economics). He is associate Professor of Finance at the Department of Administrative Sciences of the University of Quebec, Outaouais (UQO). He was Professor of Finance at the Department of Strategic Business at the University of Quebec at Montreal. He is a permanent member of the Laboratory for Research in Statistics and Probability (LRSP) and a research associate at the Chaire d’information financière et organisationnelle located at School of Business (ESG)-UQAM. He is also a consultant in financial engineering for various financial institutions in Quebec. His research fields include the theory of fixed income securities, the theory of derivative products, the empirical analysis of hedge funds, and financial engineering. His research focuses on the development of new econometric techniques for correcting and detecting specification errors in financial models, especially in the context of estimating the alpha and conditional beta of hedge funds. This research should be useful, especially for improving the selection of hedge funds used in the construction of funds of funds. He has published numerous books on quantitative finance used at the graduate level in universities and also in financial institutions as well as several articles on empirical finance in international journals.

Thorsten Schmidt is assistant professor in financial mathematics at the University of Leipzig. He has a background in statistics and probability theory and is currently working on pricing and hedging credit risk, infinite-dimensional models, shot-noise effects, and incomplete information issues. His works cover moment estimators for MARCH models; the application of SDEs on Hilbert spaces, including Lévy random fields, to credit risk, in particular to CDOs, shot-noise models applied to equity, credit, and energy markets; and the use of nonlinear filtering theory for pricing corporate securities under noisy asset information.

M. Nihat Solakoglu is an assistant professor in the Banking and Finance Department of Bilkent University in Ankara, Turkey. He was an assistant professor in the Department of Management at Fatih University. Before joining Fatih University, he worked for American Express in the United States in international risk management, international information management, and information and analysis departments. He received his PhD in economics and Masters degree in statistics from North Carolina State University. His main interests are applied finance and international finance. His papers have been published in Applied Economics, Journal of International Financial Markets, Institutions & Money, and Journal of Economic and Social Research.

Raymond Théoret, PhD, holds a doctorate in Economics (financial economics) from by the University of Montreal. He is Professor of Finance at l’École des Sciences de la Gestion (ESG) of the University of Quebec, Montreal (UQAM). He was previously Professor in financial economics at l’Institut d’Économie Appliquée located at HEC Montreal. He was an economic and financial consultant at various financial institutions in Quebec and Secretary of Campeau Commission on the improvement of the situation of financial institutions in Montreal. He has published many articles and numerous books on financial engineering, computational finance, and asset pricing. Moreover, he is the founder of the DESS (Finance) pregramat UQAM and a co-founder of the Master in Applied Finance at the same university. He teaches portfolio management theory and computational finance. His research focuses on modeling hedge fund returns with specification errors. He is an associate member of the Chaire d’information financière et organisationnelle located at ESG-UQAM.

Daniel Totouom joined the Risk Management Group at BNP Paribas in Paris in March 2003. Since November 2005, he has been based in the London office within the Product Development and Quantitative Structuring Group, where he is in charge of developing methodologies in the Exotic CDO field. Before joining the bank in 2003, Daniel was a Quantitative Analyst in Equity Derivatives at Goldman Sachs in London. He is a graduate from the Ecole Polytechnique in France and the Ecole des Mines de Paris and holds a MS degree in microelectronics.

PART ONE

Innovations in Credit Default Swaps

CHAPTER 1

The Changing Face of Credit Default Swaps

Paul U. Ali and Jan Job de Vries Robbé

ABSTRACT

Trading in credit default swaps, the most common type of credit risk transfer derivative, has grown explosively over the last decade. Much of this growth is attributable to the development of standardized market documentation for both vanilla and exotic variants of credit default swaps, the new source of liquidity provided by hedge funds, the inherent flexibility of credit default swaps, which allows for highly customized trades in credit