Risk Management

Topic One Credit yield curves and credit derivatives

1.1

Implied probability of default and credit yield curves

1.2

Credit default swaps

1.3

Credit spread and bond price based pricing

1.4

Pricing of credit derivatives

1.1

Implied probability of default and credit yield curves

The price of a corporate bond must reect not only the spot rates
for default-free bonds but also a risk premium to reect default risk
and any options embedded in the issue.
Credit spreads: compensate investor for the risk of default on the
underlying securities

 The spread increases as the rating declines. In general, it also

increases with maturity (for BBB-rating or above).
The spread tends to increase faster with maturity for low credit
ratings than for high credit ratings.

Term structures of forward probabilities of default

Year

Cumulative default probability (%)

Forward default probability in year (%)

0.2497

0.2497

0.9950

0.7453

2.0781

1.0831

3.3428

1.2647

4.6390

1.2962

0.2497% + (1 0.2497%) 0.7453% = 0.9950%

0.9950% + (1 0.9950%) 1.0831% = 2.0781%
P [def 2] = cumulative default probability up to Year 2
= 0.9950%;
P [def 2|def > 1] = forward default probability of default in Year 2
= 0.7453%.
4

Probability of default assuming no recovery

Dene
y(T ) :

Yield on a T -year corporate zero-coupon bond

y (T ) :

Yield on a T -year risk-free zero-coupon bond

Q(T ) :

Probability that corporation will default between time zero

and time T

Random time of default

The value of a T -year risk-free zero-coupon bond with a principal

of 100 is 100ey (T )T while the value of a similar corporate bond

is 100ey(T )T .

Assuming zero recovery upon default, there is a probability Q(T )

that the corporate bond will be worth zero at maturity and a probability 1 Q(T ) that it will be worth 100. The value of the risky
bond is
(T )T
(T )T
y
y
{Q(T ) 0 + [1 Q(T )] 100}e
= 100[1 Q(T )]e
.

Since the yield on the risky bond is y(T ), so

(T )T
y(T
)T
y
100e
= 100[1 Q(T )]e
.

The T -year survival probability is given by

(T )]T
[y(T
)y
S(T ) = 1 Q(T ) = e
.

Note that the probability Q(T ) is the risk neutral probability since
it is inferred from prices of traded securities.

As a summary, assuming zero recovery upon default, the survival

probability as implied from the bond prices is seen to be
price of defaultable bond
100ey(T )T
=
S(T ) =

price of default free bond

100ey (T )T
= ecredit spreadT ,
where credit spread = y(T ) y (T ). Here, the T -year credit spread
is the dierence in the yield of the risky zero-coupon and its riskfree
counterpart, both with maturity T .
Alternative proof
Assuming zero recovery and independence of the interest rate process and default event, and letting be the random default time,
we then have

0T ru du

1{ >T }] (zero recovery)

0T ru du
= E[100e
]E[1{ >T }] (independence)

price of risky bond = E[100e

= price of riskfree bond S(T ).

7

Example
Suppose that the spreads over the risk-free rate for 5-year and a 10year BBB-rated zero-coupon bonds are 130 and 170 basis points,
respectively, and there is no recovery in the event of default. The
default probabilities can be inferred from the term structure of credit
spreads as follows:
P [ 5] = Q(5) = 1 e0.0135 = 0.0629

P [ 10] = Q(10) = 1 e0.01710 = 0.1563.

The probability of default between ve years and ten years is Q(5; 10)
where
Q(10) = Q(5) + [(1 Q(5)]Q(5; 10)
or
P [ 10| > 5] = Q(5; 10) =

0.01563 0.0629
.
1 0.0629

Credit spreads and default intensities (hazard rates)

The default intensity (hazard rate) at time t is dened so that (t)t
is the probability of default between time t and t + t conditional
on no earlier default. If S(t) is the cumulative probability of the
company surviving to time t (no default by time t), then
probability of default occurring within (t, t + t]
= S(t) S(t + t) = S(t)(t)t.
Taking the limit t 0, we obtain
dS(t)
= (t) dt with S(0) = 1,
S(t)
so that
S(t) = e

0t (u) du

= e(t)t = 1 Q(t),

where Q(t) is the probability of default by time t and (t) is the

average default intensity between time 0 and time t.
9

 The average default intensity

(t) can be visualized as the credit
spread over (0, t) since
[y(t)y (t)]t

S(t) = e

= e

0 (u)

du

= e(t)t,

t [0, T ].

The unconditional default probability density q(t) is dened so

that q(t)t gives the probability of default that occurs within
(t, t + t). Let F (t) be the distribution function of the random
default time , where
F (t) = P [ t],
we then have q(t) = F (t).
Recall that q(t)t = S(t)(t)t so that
q(t) = e

0 (u)

du

(t) = S(t)(t),

t 0,

where S(t) = 1 F (t). Also, the probability of surviving until

time t, conditional on survival up to s, where s t, is given by

0t (u) du
t
e
S(t)
s
=
= e s (u) du.
P [ > t| > s] =
S(s)
e 0 (u) du

10

Recovery rates
Amounts recovered on corporate bonds as a percent of par value
from Moodys Investors Service are shown in the table below.
Class
Senior secured
Senior unsecured
Senior subordinated
Subordinated
Junior subordinated

Mean (%)

Standard derivation (%)

52.31
48.84
39.46
33.17
19.69

25.15
25.01
24.59
20.78
13.85

The amount recovered is estimated as the market value of the bond

one month after default.
Seniority of the bond among outstanding bonds issued by the
same issuer is an important determinant of the recovery rate of
that bond. Bonds that are newly issued by an issuer must have
seniority below that of existing bonds issued earlier by the same
issuer.
11

Finite recovery rate

In the event of a default, the bondholder receives a proportion
R of the bonds no-default value. If there is no default, then the
bondholder receives 100.

The bonds no-default value is 100ey (T )T and the probability

of a default is Q(T ). The value of the bond is
(T )T
(T )T
y
y
[1 Q(T )]100e
+ Q(T )100Re

so that
(T )T
(T )T
y(T
)T
y
y
100e
= [1 Q(T )]100e
+ Q(T )100Re
.

The implied probability of default in terms of yields and recovery

rate is given by

1 e[y(T )y (T )]T
Q(T ) =
.
1R

12

Numerical example on the impact of dierent assumptions of recovery rates on default probability estimation
Suppose the 1-year default free bond price is $100 and the 1-year
defaultable XY Z corporate bond price is $80.
(i) Assuming R = 0, the probability of default of XY Z as implied
by the two bond prices is
Q0(1) = 1

80
= 20%.
100

(ii) Assuming R = 0.6, we obtain

80
1 100

20%
=
= 50%.
QR (1) =
1 0.6
0.4
1 .
The ratio of Q0(1) : QR (1) = 1 : 1R
13

Calculation of default intensity with non-zero recovery rate

Consider a 5-year risky corporate bond that pays a coupon of 6%
per annum (paid semiannually)
Yield on the corporate bond is 7% per annum (with continuous
compounding)
Yield on a similar risk-free bond is 5% per annum (with continuous compounding)
The yields imply that
(i) price of the riskfree bond
= 3e0.050.5 + 3e0.051 + . . . + 3e0.054.5 + 103e0.055
= 104.09.
(ii) price of the risky bond
= 3e0.070.5 + 3e0.071 + . . . + 3e0.074.5 + 103e0.075
= 95.34.
The present value of expected loss from default over the 5-year life
of the bond = 104.09 95.34 = 8.75.
14

Let Q denote the constant unconditional probability of default per

year. Assuming that defaults can happen at times 0.5, 1.5, 2.5, 3.5
and 4.5 year (immediately before coupon payment dates), we can
calculate the expected loss from default in terms of Q.

Calculation of loss from default on a bond in terms of the default probability per
year, Q. Notional principal = $100.
Time
Default
Recovery
Risk-free Loss given Discount PV of expected
(years) probability amount($) value($) default($)
factor
loss($)
0.5
1.5
2.5
3.5
4.5
Total

Q
Q
Q
Q
Q

40
40
40
40
40

106.73
105.97
105.17
104.34
103.46

66.73
65.97
65.17
64.34
63.46

0.9753
0.9277
0.8825
0.8395
0.7985

65.08Q
61.20Q
57.52Q
54.01Q
50.67Q
288.48Q

15

Consider the 3.5 year row in the table.

The expected value of the riskfree bond at Year 3.5 (time to
expiry is 1.5 years) is
3 + 3e0.050.5 + 3e0.051.0 + 103e0.051.5 = 104.34.
The amount recovered if there is a default is 40, so the loss
given default is 104.34 40 = 64.34.
The present value of this loss = 64.34 e0.053.5 Q = 64.34
0.8395 Q = 54.01Q.
The total expected loss is 288.48Q. Setting this equal to 8.75, we
obtain Q = 3.03%.

16

Generalization - term structure of default probabilities

Suppose we have bonds maturing in 3, 5, 7, and 10 years, we could
use the rst bond to estimate a default probability per year for the
rst 3 years, the second bond to estimate default probability per
year for years 4 and 5, the third bond for years 6 and 7, and the
last bond for years 8, 9 and 10.
For example, suppose [0,3] is the default intensity in the rst 3
years, which has been obtained from an earlier calculation based
on 3-year risky and riskfree bonds. We compute [3,5] using 5-year
bonds by following the sample calculations as shown in the above,
except that the default intensity at times 0.5, 1.5 and 2.5 are set
to be the known quantity [0,3]. The default intensity at times 3.5
and 4.5 are set to be [3,5], a quantity to be determined.

17

Construction of a credit risk adjusted yield curve is hindered by

1. The general absence in money markets of liquid traded instruments on credit spread. In recent years, for some liquidly traded
corporate bonds, we may have good liquidity on trading of credit
default swaps whose underlying is the credit spread.

2. The absence of a complete term structure of credit spreads as

implied from traded corporate bonds. At best we only have
infrequent data points.

18

The default probabilities estimated from historical data are much

less than those derived from bond prices
For example, from historical data published by Moodys, an A-rated
company has average cumulative default rate Q(7) of 0.0091 =
0.91%. The average 7-year default intensity
(7) is determined by
S(7) = 1 0.0091 = 0.9909 = e(7)7

so that
1
(7) = ln 0.9909 = 0.0013 = 0.13%.
7
On the other hand, based on bond yields published by Merrill Lynch,
the average Merrill Lynch yield for A-rated bonds was 6.274%.
The average riskfree rate was estimated to be 5.505%. As an approximation, the average 7-year default intensity is
0.06274 0.05505
= 0.0128 = 1.28%.
1 0.4
Here, the recovery rate is assumed to be 0.4.
19

Seven-year average default intensities (% per annum).

Rating

Historical default

Default intensity

Ratio

Dierence

intensity

from bonds

Aaa

0.04

0.67

16.8

0.63

Aa

0.06

0.78

13.0

0.72

0.13

1.28

9.8

1.15

Baa

0.47

2.38

5.1

1.91

Ba

2.40

5.07

2.1

2.67

7.49

9.02

1.2

1.53

16.90

21.30

1.3

4.40

Caa

Corporate bonds are relatively illiquid and bond traders demand

an extra return to compensate for this.
Bonds do not default independently of each other. This gives
rise to risk that cannot be diversied away, so bond traders
should require an expected excess return for bearing the risk.
20

Implied default probabilities (equity-based versus credit-based)

Recovery rate has a signicant impact on the defaultable bond
prices. The forward probability of default as implied from the
defaultable and default free bond prices requires estimation of
the expected recovery rate (an almost impossible job).
The industrial code mKM V estimates default probability using
stock price dynamics equity-based implied default probability.
For example, the JAL stock price dropped to U1 in early 2010.
Obviously, the equity-based default probability over one year horizon
is close to 100% (stock holders receive almost nothing upon JALs
default). However, the credit-based default probability as implied by
the JAL bond prices is less than 30% since the bond par payments
are somewhat partially guaranteed even in the event of default.
21

1.2

Credit default swaps

The protection seller receives xed periodic payments from the protection buyer in return for making a single contingent payment covering losses on a reference asset following a default.

140 bp per annum

protection
buyer

protection
seller
Credit event payment
(100% recovery rate)
only if credit event occurs

holding a
risky bond

22

Protection seller
earns premium income with no funding cost
gains customized, synthetic access to the risky bond
Protection buyer
hedges the default risk on the reference asset
1. Very often, the bond tenor is longer than the swap tenor. In
this way, the protection seller does not have exposure to the full
period of the bond.
2. Basket default swap gain additional premium by selling default
protection on several assets.
23

A bank lends 10mm to a corporate client at L + 65bps. The bank

also buys 10mm default protection on the corporate loan for 50bps.
Objective achieved by the Bank through the default swap:
maintain relationship with the corporate borrower
reduce credit risk on the new loan

Risk Transfer
Default Swap
Premium
Corporate
Borrower

Interest and
Principal

Bank

If Credit Event:
par amount
If Credit Event:
obligation (loan)

Financial
House

Default swap settlement following Credit Event of Corporate Borrower

24

Settlement of compensation payment

1. Physical settlement:
The defaultable bond is put to the Protection Seller in return
for the par value of the bond.
2. Cash compensation:
An independent third party determines the loss upon default
at the end of the settlement period (say, 3 months after the
occurrence of the credit event).
Compensation amount = (1 recovery rate) bond par.

25

Selling protection
To receive credit exposure for a fee (simple credit default swaps) or
in exchange for credit exposure to better diversify the credit portfolio
(exchange credit default swaps).
Buying protection
To reduce either individual credit exposures or credit concentrations
in portfolios. Synthetically to take a short position in an asset
which are not desired to sell outright, perhaps for relationship or
tax reasons.

26

Funding cost arbitrage

Should the Protection Buyer look for a Protection Seller who has a
higher/lower credit rating than himself?
A-rated institution 50bps AAA-rated institution LIBOR-15bps Lender to the
AAA-rated
as funding
as Protection Seller annual
as Protection Buyer
Institution
cost
premium
funding cost of
coupon
LIBOR + 50bps
= LIBOR + 90bps
Lender to the
A-rated Institution

BBB risky
reference asset

27

The combined risk faced by the Protection Buyer:

default of the BBB-rated bond
default of the Protection Seller on the contingent payment
Consider the S&Ps Ratings for jointly supported obligations (the
two credit assets are uncorrelated)

A+
A

A+
AA+
AA+

A
AA+
AA

A
AA+
AA

BBB+
AA
AA

BBB
AA
AA

The AAA-rated Protection Buyer creates a synthetic AAasset with

a coupon rate of LIBOR + 90bps 50bps = LIBOR + 40bps.
This is better than LIBOR + 30bps, which is the coupon rate of a
AAasset (net gains of 10bps).
28

For the A-rated Protection Seller, it gains synthetic access to a

BBB-rated asset with earning of net spread of

Funding cost of the A-rated Protection Seller = LIBOR + 50bps

Coupon from the underlying BBB bond = LIBOR + 90bps
Credit swap premium earned = 50bps

29

In order that the credit arbitrage works, the funding cost of the
default protection seller must be higher than that of the default
protection buyer.
Example
Suppose the A-rated institution is the Protection Buyer, and assume
that it has to pay 60bps for the credit default swap premium (higher
premium since the AAA-rated institution has lower counterparty
risk).
spread earned from holding the risky bond
= coupon from bond funding cost
= (LIBOR + 90bps) (LIBOR + 50bps) = 40bps
which is lower than the credit swap premium of 60bps paid for
hedging the credit exposure. No deal is done!

30

Counterparty risk in CDS

Before the Fall 1997 crisis, several Korean banks were willing to
oer credit default protection on other Korean rms.

US commercial
bank

40 bp

Korea exchange
bank

LIBOR + 70bp
Hyundai
(not rated)
Higher geographical risks lead to higher default correlations.
Higher geographic risks lead to higher default correlations.
Advice: Go for a European bank to buy the protection.
31

How does the inter-dependent default risk structure between the

Protection Seller and the Reference Obligor aect the credit swap
premium rate?

1. Replacement cost (Seller defaults earlier)

If the Protection Seller defaults prior to the Reference Entity, then the Protection Buyer renews the CDS with a new
counterparty.
Supposing that the default risks of the Protection Seller and
Reference Entity are positively correlated, then there will be
an increase in the swap rate of the new CDS.

2. Settlement risk (Reference Entity defaults earlier)

The Protection Seller defaults during the settlement period
after the default of the Reference Entity.
32

Hedge strategy using fixed-coupon bonds

Portfolio 1
One defaultable coupon bond C; coupon c, maturity tN .
One CDS on this bond, with CDS spread s
The portfolio is unwound after a default.
Portfolio 2
One default-free coupon bond C: with the same payment dates
as the defaultable coupon bond and coupon size c s.
The default free bond is sold after default of the defaultable counterpart.
33

Comparison of cash ows of the two portfolios

1. In survival, the cash ows of both portfolio are identical.

t=0
t = ti
t = tN

Portfolio 1
C(0)
cs
1+cs

Portfolio 2
C(0)
cs
1+cs

2. At default, portfolio 1s value = par = 1 (full compensation by

the CDS); that of portfolio 2 is C( ), is the time of default.
The price dierence at default = 1 C( ). This dierence is
very small when the default-free bond is a par bond.

Remark
The issuer can choose c to make the bond be a par bond such that
the initial value of the bond is at par.
34

This is an approximate replication.

Recall that the value of the CDS at time 0 is zero. Let B(0, tN )
denote the price of a zero-coupon default-free bond. Neglecting
the dierence in the values of the two portfolios at default, the
no-arbitrage principle dictates
C(0) = C(0) = B(0, tN ) + cA(0) sA(0).
Here, (c s)A(0) is the sum of present value of the coupon payments at the xed coupon rate c s. The equilibrium CDS rate s
can be solved:
B(0, tN ) + cA(0) C(0)
.
s=
A(0)
B(0, tN ) + cA(0) is the time-0 price of a default free coupon bond
paying coupon at the rate of c.

35

Cash-and-carry arbitrage with par floater

A par oater C is a defaultable bond with a oating-rate coupon

of ci = Li1 + spar , where the par spread spar is adjusted such that
at issuance the par oater is valued at par.
Portfolio 1

One defaultable par oater C with spread spar over LIBOR.

One CDS on this bond: CDS spread is s.

The portfolio is unwound after default.

36

Portfolio 2
One default-free oating-coupon bond C : with the same payment dates as the defaultable par oater and coupon at LIBOR,
ci = Li1.
The bond is sold after default.
Time
t=0
t = ti
t = tN
(default)

Portfolio 1
1
Li1 + spar s
1 + LN 1 + spar s
1

Portfolio 2
1
Li1
1 + LN 1

C ( ) = 1 + Li( ti )

The hedge error in the payo at default is caused by accrued interest

Li( ti), accumulated from the last coupon payment date ti to the
default time . If we neglect the small hedge error at default, then
spar = s.

37

Remarks
The non-defaultable bond becomes a par bond (with initial value
equals the par value) when it pays the oating rate equals LIBOR. The extra coupon spar paid by the defaultable par oater
represents the credit spread demanded by the investor due to
the potential credit risk. The above result shows that the credit
spread spar is just equal to the CDS spread s.
The above analysis neglects the counterparty risk of the Protection Seller of the CDS. Due to potential counterparty risk,
the actual CDS spread will be lower.

38

Valuation of Credit Default Swap

Suppose that the probability of a reference entity defaulting
during a year conditional on no earlier default is 2%. That is,
the default intensity is assumed to be the constant 2%.
Table 1 shows the survival probabilities and forward default probabilities (i.e., default probabilities as seen at time zero) for each
of the 5 years. The probability of a default during the rst year
is 0.02 and the probability that the reference entity will survive
until the end of the rst year is 0.98.
The forward probability of a default during the second year is
0.02 0.98 = 0.0196 and the probability of survival until the end
of the second year is 0.98 0.98 = 0.9604.

39

Table 1 Forward default probabilities and survival probabilities

Time (years)

Default probability

Survival probability

0.0200

0.9800

0.0196

0.9604 = 0.982

0.0192

0.9412 = 0.983

0.0188

0.9224 = 0.984

0.0184

0.9039 = 0.985

P [3 < 4]
= forward default probability of default during the fourth year (as
seen at current time)
= P [ > 3] P [3 < 4| > 3]
= survival probability until end of Year 3 conditional probability
of default in Year 4
= 0.983 0.02 = 0.9412 0.02 = 0.0188.
40

Assumptions on default and recovery rate

We will assume the defaults always happen halfway through a year
and that payments on the credit default swap are made once a year,
at the end of each year. We also assume that the risk-free (LIBOR)
interest rate is 5% per annum with continuous compounding and
the recovery rate is 40%.
Expected present value of CDS premium payments
Table 2 shows the calculation of the expected present value of the
payments made on the CDS assuming that payments are made at
the rate of s per year and the notional principal is $1.
For example, there is a 0.9412 probability that the third payment
of s is made. The expected payment is therefore 0.9412s and its
present value is 0.9412se0.053 = 0.8101s. The total present value
of the expected payments is 4.0704s.
41

Table 2 Calculation of the present value of expected payments.

Payment = s per annum.

Time
Probability
(years) of survival

Expected
payment

Discount
factor

PV of expected
payment

0.9800

0.9800s

0.9512

0.9322s

0.9604

0.9604s

0.9048

0.8690s

0.9412

0.9412s

0.8607

0.8101s

0.9224

0.9224s

0.8187

0.7552s

0.9039

0.9039s

0.7788

0.7040s

Total

4.0704s

42

Table 3 Calculation of the present value of expected payo. Notional principal = $1.
Time
(years)

Probability
of default

Recovery
rate

Expected
payo ($)

Discount
factor

PV of expected
payo ($)

0.5

0.0200

0.4

0.0120

0.9753

0.0117

1.5

0.0196

0.4

0.0118

0.9277

0.0109

2.5

0.0192

0.4

0.0115

0.8825

0.0102

3.5

0.0188

0.4

0.0113

0.8395

0.0095

4.5

0.0184

0.4

0.0111

0.7985

0.0088

Total

0.0511

For example, there is a 0.0192 probability of a payo halfway through

the third year. Given that the recovery rate is 40%, the expected
payo at this time is 0.0192 0.6 1 = 0.0115. The present value
of the expected payo is 0.0115e0.052.5 = 0.0102.
The total present value of the expected payos is $0.0511.
43

 When default occurs in mid-year, the Protection Buyer has to

pay the premium accrued half year (between the last premium
payment date and default time).

Table 4 Calculation of the present value of accrual payment.

Time
Probability
(years) of default

Expected
accrual
payment

Discount
factor

PV
of
expected accrual
payment

0.5

0.0200

0.0100s

0.9753

0.0097s

1.5

0.0196

0.0098s

0.9277

0.0091s

2.5

0.0192

0.0096s

0.8825

0.0085s

3.5

0.0188

0.0094s

0.8395

0.0079s

4.5

0.0184

0.0092s

0.7985

0.0074s

Total

0.0426s
44

As a nal step we evaluate in Table 4 the accrual payment made in

the event of a default.
There is a 0.0192 probability that there will be a nal accrual
payment halfway through the third year.
The accrual payment is 0.5s.
The expected accrual payment at this time is therefore 0.0192
0.5s = 0.0096s.
Its present value is 0.0096se0.052.5 = 0.0085s.
The total present value of the expected accrual payments is
0.0426s.

From Tables 2 and 4, the present value of the expected payment is

4.0704s + 0.0426s = 4.1130s.
45

Equating expected CDS premium payments and expected compensation payment

From Table 3, the present value of the expected payo is 0.0511.
Equating the two, we obtain the CDS spread for a new CDS as
4.1130s = 0.0511
or s = 0.0124. The mid-market spread should be 0.0124 times the
principal or 124 basis points per year.
In practice, we are likely to nd that calculations are more extensive
than those in Tables 2 to 4 because

(a) payments are often made more frequently than once a year
(b) we might want to assume that defaults can happen more frequently than once a year.

46

Impact of expected recovery rate R on credit swap premium s

Recall that the expected compensation payment paid by the Protection Seller is (1 R) notional. Therefore, the Protection Seller
charges a higher s if her estimation of the recovery rate R is lower.
Let sR denote the credit swap premium when the recovery rate is
R. We deduce that
90%
s10
(100 10)%
=
=
= 1.8.
s50
(100 50)%
50%
Remark
A binary credit default swap pays the full notional upon default
of the reference asset. The credit swap premium of a binary swap
depends only on the estimated default probability but not on the
recovery rate.

47

Marking-to-market a CDS
At the time it is negotiated, a CDS, like most swaps, is worth
zero. Later, it may have a positive or negative value.
Suppose, for example the credit default swap in our example
had been negotiated some time ago for a spread of 150 basis
points, the present value of the payments by the buyer would be
4.1130 0.0150 = 0.0617 and the present value of the payo
would be 0.0511.
The value of swap to the seller would therefore be 0.0617
0.0511, or 0.0166 times the principal.
Similarly the mark-to-market value of the swap to the buyer of
protection would be 0.0106 times the principal.

48

Basket default swaps

The credit event to insure against using the kth-to-default credit
default swap is the event of the kth default. A premium or spread
s is paid as an insurance fee until maturity or the event of the
kth default, whichever comes rst. If the kth default occurs before
swaps maturity, the Protection Buyer puts the defaulting bond to
the Protection Seller in exchange for the face value of the bond.
Sum of the kth-to-default swap spreads, k = 1, 2, . . . , n, for n obligors
in total in the basket is greater than the sum of the individual spreads
of the same set of n obligors:
n

k=1

sk >

si .

i=1

Why? Apparently, both sides insure exactly the same set of risks:
the n defaults in the basket. At the time of the rst default, the
left side stops paying the huge spread s1 while on the plain-vanilla
side one just stops paying the spread si of the rst default that falls
on obligor i.
49

Bounds on the swap premiums for the rst-to-default (FtD) swaps

under low default correlation
Assuming all 3 obligors have the same dollar exposure, we have
fee on CDS on fee on FtD portfolio of
worst credit
swap
CDSs on all
credits

sC

sFtD

sA +
sB +
sC
With low default probabilities and low default correlation, we have

sFtD
sA +
sB +
sC .
To see this, by assuming zero default correlation, the probability of
at least one default is
p = 1 (1 pA)(1 pB )(1 pC )
= pA + pB + pC (pApB + pApC + pB pC ) + pApB pC
so that
p / pA + pB + pC

for small

pA, pB and pC .
50

1.3

Credit spread and bond price based pricing

Markets assessment of the default risk of the obligor (assuming

some form of market eciency information is aggregated in the
market prices). The sources are
market prices of bonds and other defaultable securities issued
by the obligor
prices of CDSs referencing this obligors credit risk
How to construct a clean term structure of credit spreads from
observed market prices?

51

Based on no-arbitrage pricing principle, a model that is based upon

and calibrated to the prices of traded assets is immune to simple
arbitrage strategies using these traded assets.
Market instruments used in bond price-based pricing
At time t, the defaultable and default-free zero-coupon bond
prices of all maturities T t are known. These defaultable
zero-coupon bonds have no recovery at default.
Information about the probability of default over all time horizons as assessed by market participants are fully reected when
market prices of default-free and defaultable bonds of all maturities are available.

52

Risk neutral probabilities

The nancial market is modeled by a ltered probability space (,
(Ft)t0, F , Q), where Q is the risk neutral probability measure.
All probabilities and expectations are taken under Q. Probabilities are considered as state prices.
1. For constant interest rates, the discounted Q-probability of
an event A at time T is the price of a security that pays o
$1 at time T if A occurs.
2. Under stochastic interest rates, the price of the contingent
claim associated with A is E[(T )1A], where (T ) is the discount factor. This is based on the risk neutral valuation
prin
T
1
ciple and the money market account M (T ) =
= e t ru du
(T )
is used as the numeraire.

53

Indicator functions
{

For A F , 1A() =

1 if A
.
0 otherwise

= random time of default; I(t) = survival indicator function

{

I(t) = 1{ >t} =

1 if > t
.
0 if t

B(t, T ) = price at time t of zero-coupon bond paying o $1 at T

B(t, T ) = price of defaultable zero-coupon bond if > t;
{

I(t)B(t, T ) =

B(t, T ) if > t
.
0
if t

54

Monotonicity properties on the bond prices

1. 0 B(t, T ) < B(t, T ),

t < T

2. Starting at B(t, t) = B(t, t) = 1,

B(t, T1) B(t, T2) > 0

and

B(t, T1) B(t, T2) 0

t < T1 < T2, > t.

Independence assumption
{B(t, T )|t T } and are independent under (, F , Q) (not the true
measure).

55

Implied probability of survival in [t, T ] based on market prices

of bonds
[

B(t, T ) = E e

T
t

ru du

and

B(t, T ) = E e

T
t

ru du

I(T ) .

Invoking the independence between defaults and the default-free

interest rates
[

B(t, T ) = E e

T
t

ru du

E[I(T )] = B(t, T )P (t, T )

implied survival probability over [t, T ] = P (t, T ) =

B(t, T )
.
B(t, T )

56

 The implied default probability over [t, T ], Pdef (t, T ) = 1P (t, T ).

Assuming P (t, T ) has a right-sided derivative in T , the implied
density of the default time
Q[ (T, T + dT ]|Ft] =

P (t, T ) dT.
T

If prices of zero-coupon bonds for all maturities are available,

then we can obtain the implied survival probabilities for all maturities (complementary distribution function of the time of default).

57

Properties on implied survival probabilities, P (t, T )

1. P (t, t) = 1 and it is non-negative and decreasing in T . Also,
P (t, ) = 0.
2. Normally P (t, T ) is continuous in its second argument, except
that an important event secheduled at some time T1 has direct
inuence on the survival of the obligor.
3. Viewed as a function of its rst argument t, all survival probabilities for xed maturity dates will tend to increase.

If we want to focus on the default risk over a given time interval in

the future, we should consider conditional survival probabilities.
conditional survival probability over [T1, T2] as seen from t
P (t, T2)
= P (t, T1, T2) =
, where t T1 < T2.
P (t, T1)

58

Implied hazard rate (default probabilities per unit time interval length)
Discrete implied hazard rate of default over (T, T + T ] as seen
from time t
H(t, T, T + T )T =

Pdef (t, T, T + T )
P (t, T )
1=
,
P (t, T + T )
P (t, T, T + T )

so that
P (t, T ) = P (t, T + T )[1 + H(t, T, T + T )T ].
In the limit of T 0, the continuous hazard rate at time T as
seen at time t is given by

h(t, T ) =
ln P (t, T ).
T

59

Proof

First, we recall
1
P (t, T )
=
.
P (t, T, T + T )
P (t, T, T + T )

We have
h(t, T ) =
=
=
=
=
=

lim H(t, T, T + T )

T 0

1 P (t, T, T + T )
T 0 T P (t, T, T + T )
[
]
P (t, T )
1
1
lim
T 0 T P (t, T + T )
1
P (t, T + T ) P (t, T )
lim
T 0 P (t, T + T )
T
1

P (t, T )
P (t, T ) T

ln P (t, T ).

T
lim

60

Forward spreads and implied hazard rate of default

For t T1 < T2, the simply compounded forward rate over the
period (T1, T2] as seen from t is given by
F (t, T1, T2) =

B(t, T1)/B(t, T2) 1

.
T2 T1

This is the price of the forward contract with expiration date T1 on

a unit-par zero-coupon bond maturing on T2. To prove, we consider
the compounding of interest rates over successive time intervals.
1
B(t, T )
| {z 2 }

compounding over [t, T2 ]

1
B(t, T )
| {z 1 }

[1
+ F (t, T1,{z
T2)(T2 T1)]}
|
simply compounding over [T1 , T2 ]

compounding over [t, T1 ]

Defaultable simply compounded forward rate over [T1, T2]

F (t, T1, T2) =

B(t, T1)/B(t, T2) 1

.
T2 T1

61

Instantaneous continuously compounded forward rates

ln B(t, T )
T 0
T

f (t, T ) = lim F (t, T, T + T ) =

ln B(t, T ).
T 0
T
f (t, T ) =

lim F (t, T, T + T ) =

Implied hazard rate of default

Recall
B(t, T2) B(t, T1)
B(t, T2) B(t, T1)
1 + F (t, T1, T2)(T2 T1)
= 1 Pdef (t, T1, T2),
=
1 + F (t, T1, T2)(T2 T1)

P (t, T1, T2) =

and upon expanding, we obtain

Pdef (t, T1, T2) [1
+ F (t, T1,{z
T2)(T2 T1)]} = [F (t, T1, T2)F (t, T1, T2)](T2T1).
|
B(t,T1)/B(t,T2 )

62

Dene H(t, T1, T2) =

Pdef (t, T1, T2)

(T2 T1)P (t, T1, T2)

rate of default. We then have

as the discrete implied

B(t, T2) [F (t, T1, T2) F (t, T1, T2)]

B(t, T1)
P (t, T1, T2)
B(t, T2)
[F (t, T1, T2) F (t, T1, T2)].
=
B(t, T1)

H(t, T1, T2) =

Taking the limit T2 T1, then the implied hazard rate of default at
time T > t as seen from time t is the spread between the forward
rates:
h(t, T ) = f (t, T ) f (t, T ).
Alternatively, we obtain the above relation using

B(t, T )
ln
f (t, T ) f (t, T ) =
T
B(t, T )

=
ln P (t, T ) = h(t, T ).
T
63

The local default probability at time t over the next small time step
t
1
Q[ t + t|Ft { > t}] r(t) r(t) = (t)
t
where r(t) = f (t, t) is the riskfree short rate and r(t) = f (t, t) is the
defaultable short rate.
Recovery value
View an asset with positive recovery as an asset with an additional
positive payo at default. The recovery value is the expected value
of the recovery shortly after the occurrence of a default.

64

Payment upon default

Dene e(t, T, T +T ) to be the value at time t < T of a deterministic
payo of $1 paid at T + T if and only if a default happens in
[T, T + T ].
e(t, T, T + T ) = EQ [(t, T + T )[I(T ) I(T + T )]|Ft] .
Note that

I(T ) I(T + T ) =

1 if default occurs in [T, T + T ]

,
0 otherwise

EQ[(t, T + T )I(T )] = EQ[(t, T + T )]EQ[I(T )]

= B(t, T + T )P (t, T ),
EQ[(t, T + T )I(T + T )] = B(t, T + T ),
and
B(t, T + T ) = B(t, T + T )/P (t, T + T ).

65

It is seen that
e(t, T, T + T ) = B(t, T + T )P[ (t, T ) B(t, T + T
)
]
P (t, T )
= B(t, T + T )
1
P (t, T + T )
= T B(t, T + T )H(t, T, T + T )
On taking the limit T 0, we obtain
rate of default compensation

e(t, T, T + T )
= e(t, T ) = lim
T 0
T
= B(t, T )h(t, T ) = B(t, T )P (t, T )h(t, T ).

The value of a security that pays (s) if a default occurs at time s

for all t < s < T is given by
T
t

(s)e(t, s) ds =

(s)B(t, s)h(t, s) ds.

This result holds for deterministic recovery rates.

66

Random recovery value

Suppose the payo at default is not a deterministic function
( ) but a random variable which is drawn at the time of
default . is called a marked point process. Dene
e(t, T ) = EQ[ |Ft { = T }].
which is the expected value of conditional on default at T and
information at t.
Conditional on a default occurring at time T , the price of a
security that pays at default is B(t, T )e(t, T ).
Since the time of default is not known, we have to integrate
these values over all possible default times and weight them
with the respective probability of default occurring.
The price at time t of a payo of at if [t, T ] is given by
T
t

e(t, s) B(t,
s)P
(t, s)} h(t, s) ds.
|
{z
B(t,s)
67

Building blocks for credit derivatives pricing

Tenor structure

k = Tk+1 Tk , 0 k K 1

Coupon and repayment dates for bonds, xing dates for rates, payment and settlement dates for credit derivatives all fall on Tk , 0
k K.

68

Fundamental quantities of the model

Term structure of default-free interest rates F (0, T )
Term structure of implied hazard rates H(0, T )
Expected recovery rate (rate of recovery as percentage of par)
B(0, Ti1)
, i = 1, 2, , k, and B(0, T0) =
1 + i1F (0, Ti1Ti)
B(0, 0) = 1, we obtain
From B(0, Ti) =

1
B(0, Tk ) =
.
1
+

F
(0,
T
,
T
)
i1
i1 i
i=1
P (0, Ti1)
Similarly, from P (0, Ti) =
, we deduce that
1 + i1H(0, Ti1, Ti)
B(0, Tk ) = B(0, Tk )P (0, Tk ) = B(0, Tk )

1
.
i=1 1 + i1 H(0, Ti1 , Ti)

e(0, Tk , Tk+1) = k H(0, Tk , Tk+1)B(0, Tk+1)

= value of $1 at Tk+1 if a default
has occurred in (Tk , Tk+1].
69

Taking the limit i 0, for all i = 0, 1, , k

(

B(0, Tk ) = exp
(

B(0, Tk ) = exp

T
k
0
T
k
0

f (0, s) ds
)

[h(0, s) + f (0, s)] ds

e(0, Tk ) = h(0, Tk )B(0, Tk ).

Alternatively, the above relations can be obtained by integrating
f (0, T ) =

ln B(0, T )
T

with

f (0, T ) = h(0, T ) + f (0, T ) =

B(0, 0) = 1

ln B(0, T )
T

with

B(0, 0) = 1.

70

Defaultable xed coupon bond

K

c(0) =

cnB(0, Tn)

(coupon)

cn = cn1

n=1

+ B(0, TK )
+

(principal)

e(0, Tk1, Tk )

(recovery)

k=1

The recovery payment can be written as

k=1

e(0, Tk1, Tk ) =

k1H(0, Tk1, Tk )B(0, Tk ).

k=1

The recovery payments can be considered as an additional coupon

payment stream of k1H(0, Tk1, Tk ).

71

Defaultable oater
Recall that L(Tn1, Tn) is the reference LIBOR rate applied over
[Tn1, Tn] at Tn1 so that 1 + L(Tn1, Tn)n1 is the growth factor
over [Tn1, Tn]. Application of no-arbitrage argument gives
B(Tn1, Tn) =

1
1 + L(Tn1, Tn)n1

The coupon payment at Tn equals LIBOR plus a spread

[

]
par
n1 L(Tn1, Tn) + s
=

Consider the payment of

1
B(Tn1, Tn)

1
B(Tn1, Tn)

1 + spar n1.

at Tn, its value at Tn1

B(Tn1, Tn)
is
= P (Tn1, Tn). Why? We use the defaultable
B(Tn1, Tn)
discount factor B(Tn1, Tn) since the coupon payment may be
defaultable over [Tn1, Tn].
72

 Seen at t = 0, the value becomes

B(0, Tn1)P (0, Tn1, Tn)
= B(0, Tn1)P (0, Tn1)P (0, Tn1, Tn)
= B(0, Tn1)P (0, Tn).
Combining with the xed part of the coupon payment and observing
the relation
]

B(0, Tn1)
1 B(0, Tn)
B(0, Tn)
= n1F (0, Tn1, Tn)B(0, Tn),

[B(0, Tn1) B(0, Tn)]P (0, Tn) =

the model price of the defaultable oating rate bond is

c(0) =

n1F (0, Tn1, Tn)B(0, Tn) + spar

n=1

+ B(0, TK ) +

n1B(0, Tn)

n=1
K

e(0, Tk1, Tk ).

k=1
73

1.4

Pricing of credit derivatives

Credit default swap revisited

Fixed leg

Payment of n1s at Tn if no default until Tn.

The value of the xed leg is
s

n1B(0, Tn).

n=1

Floating leg

Payment of 1 at Tn if default in (Tn1, Tn]

occurs. The value of the oating leg is
(1 )
= (1 )

e(0, Tn1, Tn)

n=1
N

n1H(0, Tn1, Tn)B(0, Tn).

n=1
74

The market CDS spread is chosen such that the xed leg and oating leg of the CDS have the same value. Hence
N

n1H(0, Tn1, Tn)B(0, Tn)

s = (1 ) n=1

N
n=1 n1 B(0, Tn)

Dene the weights

wn =

n1B(0, Tn)
N

n = 1, 2, , N,

and

wn = 1,

n=1

k1B(0, Tk )

k=1

then the fair swap premium rate is given by

s = (1 )

wnH(0, Tn1, Tn).

n=1

75

1. s depends only on the defaultable and default free discount rates,

which are given by the market bond prices. CDS is an example
of a cash product.
2. It is similar to the calculation of xed rate in the interest rate
swap
s=

F (0, T
wn
n1 , Tn)

n=1

where

=
wn

n1B(0, Tn)
N

n = 1, 2, , N.

k1B(0, Tk )

k=1

76

Marked-to-market value
original CDS spread = s; new CDS spread = s
Let = CDSold CDSnew , and observe that CDSnew = 0, then
marked-to-market value = CDSold = = (s s)

B(0, Tn)n1.

n=1

Why? If an osetting trade is entered at the current CDS rate s,

only the fee dierence (s s) will be received over the life of the
CDS. Should a default occurs, the protection payments will cancel
out, and the fee dierence payment will be cancelled, too. The
fee dierence stream is defaultable and must be discounted with
B(0, Tn).
CDSs are useful instruments to gain exposure against spread
movements, not just against default arrival risk.

77

Hedge based pricing approximate hedge and replication strategies

Provide hedge strategies that cover much of the risks involved in
credit derivatives independent of any specic pricing model.
Basic instruments

1. Default free bond

C(t) = time-t price of default-free bond with xed-coupon C
B(t, T ) = time-t price of default-free zero-coupon bond
2. Defaultable bond
C(t) = time-t price of defaultable bond with xed-coupon c

C (t) = time-t price of defaultable bond with oating coupon

LIBOR + spar

78

3. Interest rate swap

S(t) = swap rate at time t of a standard xed-for-oating
B(t, tn) B(t, tN )
=
, t tn
A(t; tn, tN )
where A(t; tn, tN ) =

iB(t, ti) = value of the payment stream

i=n+1
paying i on each date ti.

Proof of the swap rate formula

The oating rate coupon payments can be generated by putting $1
at tn and taking away the oating interests immediately. At tN ,
$1 remains. The sum of the present value of the oating interests
= B(t, tn) B(t, tN ).
Intuition behind cash-and-carry arbitrage pricing of CDSs
A combined position of a CDS with a defaultable bond C is very
well hedged against default risk.
79

Asset swap packages

An asset swap package consists of a defaultable coupon bond C with
coupon c and an interest rate swap. The bonds coupon is swapped
into LIBOR plus the asset swap rate sA. Asset swap package is sold
at par.
Remark Asset swap transactions are driven by the desire to strip
out unwanted structured features from the underlying asset.
Payo streams to the buyer of the asset swap package

time
t=0
t = ti
t = tN
default
*

defaultable bond
C(0)
c
(1 + c)
recovery

swap
1 + C(0)
c + Li1 + sA
c + LN 1 + sA
unaected

net
1
Li1 + sA + (c c)
1 + LN 1 + sA + (c c)
recovery

denotes payment contingent on survival.

80

s(0) = xed-for-oating swap rate (market quote)

A(0) = value of an annuity paying at the $1 (calculated based on
observable default free bond prices)
The value of asset swap package is set at par at t = 0, so that
A(0) A(0)c = 1.
C(0) + A(0)s(0)
+
A(0)s
|
{z
}
swap arrangement

The present value of the oating coupons is given by A(0)s(0). The

swap continues even after default so that A(0) appears in all terms
associated with the swap arrangement.

81

Solving for sA(0)

sA(0) =

1
[1 C(0)] + c s(0).
A(0)

Rearranging the terms,

C(0) + A(0)sA(0) = [1
A(0)s(0)]
+ A(0)c} C(0)
|
{z
default-free bond
where the right-hand side gives the value of a default-free bond with
coupon c. Note that 1 A(0)s(0) is the present value of receiving
$1 at maturity tN . We obtain
sA(0) =

1
[C(0) C(0)].
A(0)

82

Credit spread options

The terminal payo is given by
Psp(r, s, T ) = max(s K, 0)
where r = riskless interest rate
s = credit spread
K = strike spread
Discrete-time Heath-Jarrow-Morton (HJM) method
Follows the HJM term structure approach that models the forward rate process and forward spread process for riskless and
risky bonds.
The model takes the observed term structures of riskfree forward
rates and credit spreads as input information.
Find the risk neutral drifts of the stochastic processes such that
all discounted security prices are martingales.

83

Example Price a one-year put spread option on a two-year risky

zero-coupon bond struck at the strike spread K = 0.01.
Let the current observed term structure of riskless interest rates as
obtained from the spot rate curve for Treasury bonds be
(

r=

0.07
0.08

The riskless forward rate between year one and year two is
1.082
f12 =
1 0.09.
1.07
The market one-year and two-year spot spreads are
(

s=

0.010
0.012

84

The two-year risky rate is 0.08 + 0.012 = 0.092. The current price
of a risky two-year zero coupon bond with face value $100 is
B(0) = $100/(1.092)2 = $83.86.
The discrete stochastic process for the spread under the true
measure is assumed to take theform of a square-root process
where the volatility depends on s(0)

s(t) = s(0) + k[ s(0)]t s(0)t

where k = 0.3, = 0.02 and = 0.04, t = 1, s(0) = 0.01.

85

 We need to add an adjustment term in the drift term in order

to risk-adjust the stochastic forward spread process

s(t) = s(0) + k[ s(0)]t + s(0)t.

The adjustment term is determined by requiring the discounted
bond prices to be martingales.
Let B(1) denote the price at t = 1 of the risky bond maturing
at t = 2. The forward defaultable discount factor over year one
1
and year two is
, where s(1) is the forward spread
1 + f12 + s(1)
over the period.
{

s(1) =

+ 0.017
+ 0.009

100

1+f12++0.017

so that B(1) =

100
1+f12 ++0.009 ,

with equal probabilities for assuming the high and low values.

86

We determine such that the bond price is a martingale.

(

B(0) = 83.86 =

1
1
100
100

+
.
1 + 0.07 + 0.01 2 1.107 +
1.099 +

The rst term is the risky defaultable discount factor and the last
term is {the expected value of B(1). We obtain = 0.0012 so that
0.0182
s(1) =
.
0.0102
The current value of put spread option is
1
1
[(0.0182 0.01) + (0.0102 0.01)]L = 0.00393L,
1.07 2
where L is the notional value of the put spread option. Note that
the default free discount factor 1/1.07 is used in the option value
calculation.

87