Chapter 20. Credit Derivatives

This chapter explains how the main types of credit derivatives work and how they are valued. Central to the valuation of credit derivatives is an estimation of the probability that reference entities will default. The chapter discusses both the risk-neutral probabilities of default implied from credit spreads and the real-world (physical) default probabilities calculated from historical data, such as that provided by rating agencies. The academic literature attempting to explain the difference between these two probability estimates is summarized. The characteristics of credit default swaps, which are the most common type of single-name derivatives, are discussed, and procedures used to determine the contract values are explained. A similar presentation is provided for collateralized debt obligations, which are the most common type of multi-name credit derivatives. The chapter ends with a discussion of the economics of the collateralized debt obligation market and the role that these products played in the US financial crisis, which started in 2007.