N th‐to‐default swaps: valuation and analysis

Purpose – Credit derivatives continue to grow in popularity as well as complexity. While single‐name credit default swaps are still the most popular instruments, second‐generation products have become more commonplace. Second generation products are those whose payoffs are contingent on the viability of a number of firms and include instruments such as default baskets and synthetic collateralized debt obligations. The purpose of this paper is to provide a transparent and detailed account of default basket valuation along with thorough and intuitive explanations of comparative statics and the relationship between basket values and default correlation. Design/methodology/approach – The paper delineates the standard approach to valuing default baskets and with its implementation examines results for two copula functions and the input assumptions which are critical to the valuation process. Findings – It is found that the assumptions are critical to the valuation and that the copula chosen also has an impact on pricing and comparative statics. Practical implications – This paper is very practical in its orientation and takes a pedagogical approach in its explanation of default baskets, the standard model, and key assumptions. Originality/value – This paper fills a gap in the literature as prior works are more focused on certain enhancements or nuances of modeling basket credit derivatives while this work centers on the standard model and provides a thorough analysis and explanation of the comparative statics as well as a discussion of model limitations. This paper is ideal reading for those that seek an understanding of the modeling and risks associated with multi‐name credit derivatives.