C.02.Hull 23 / Coval

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  1. Cr derivative
    • make pmt if a specific cpy defaults. Uses include
    • reduce risk exposure to a specific counterparty
    • diversify risk (buy when exposed, sell otherwise)
  2. CDS = credit default swap
    • protects agains cr event of reference entity
    • buyer makes periodic pmts = CDS spread
    • if cr event occurs, buyer can sell bd for notional principal and not futher CDS spread is required except accrual
  3. CDS settlement types
    • physical settlement: sell bds at face value
    • cash settlement: seller pays diff btwn face value and value of cheapest avail bond
  4. CDS swap & bond yield
    • CDS spread = yield on corp bd - rf
    • CDS-bond basis: expected to be zero
  5. Valuation of CDS
    • PV(exp pmt) + PV(accrual pmt) = PV(exp payoff)
    • PV(accrual) = default prob * s/2 * disc
    • PV(exp pmt) = survival prob * s * disc
    • PV(exp payoff) = default prob * (1 - R) * disc
    • can assume more frequent pmt or default
    • when issued, value = 0; chg as spread chg
  6. ABS = asset backed securities
    • security made up of a pf of financial assets
    • firm transfers to SPV = special purpose vehicle
    • SPV issues securities backed by CF of assets
    • high rating of first tranche not justified if assets are highly corr
    • CDO-squared: repackaging of mezzanine tranches
  7. CDO = collateralized debt obligation
    • type of ABS where assets are corp or country bds
    • long bond = short CDS
    • synthetic CDO: CDO w short CDS
  8. 2008 financial crisis
    • rating agencies provided ratings to financial instruments (original mandate = single-name corporation) -> correlation
    • amt of non-conforming mortgages incr while quality of subprime borrowers deteriorated
    • CMO biased against investors: (1) higher prob of default due to quality of borrowers (2) lower R due to pressure to sell (3) high correlation (4) high impact of errors in estimate
Card Set
C.02.Hull 23 / Coval
Cr Derivatives; Economics of Structured Finance
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