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Credit Derivatives: Trading, Investing,and Risk Management, 2nd Edition


The credit derivatives industry has come under close scrutiny over the past few years, with the recent financial crisis highlighting the instability of a number of credit structures and throwing the industry into turmoil. What has been made clear by recent events is the necessity for a thorough understanding of credit derivatives by all parties involved in a transaction, especially traders, structurers, quants and investors.

Fully revised and updated to take in to account the new products, markets and risk requirements post financial crisis, Credit Derivatives: Trading, Investing and Risk Management, Second Edition, covers the subject from a real world perspective, tackling issues such as liquidity, poor data, and credit spreads, to the latest innovations in portfolio products, hedging and risk management techniques.

The book concentrates on practical issues and develops an understanding of the products through applications and detailed analysis of the risks and alternative means of trading.

It provides:

  • a description of the key products, applications, and an analysis of typical trades including basis trading, hedging, and credit structuring;
  • analysis of the industry standard 'default and recovery' and Copula models including many examples, and a description of the models' shortcomings;
  • tools and techniques for the management of a portfolio or book of credit risks including appropriate and inappropriate methods of correlation risk management;
  • a thorough analysis of counterparty risk;
  • an intuitive understanding of credit correlation in reality and in the Copula model.

The book is thoroughly updated to reflect the changes the industry has seen over the past 5 years, notably with an analysis of the lead up and causes of the credit crisis. It contains 50% new material, which includes copula valuation and hedging, portfolio optimisation, portfolio products and correlation risk management, pricing in illiquid environments, chapters on the evolution of credit management systems, the credit meltdown and new chapters on the implementation and testing of credit derivative models and systems.

The book is accompanied by a CD ROM which contains tools for credit derivatives valuation and risk management, illustrating the models used in the book and also providing a valuation toolkit.

GEOFF CHAPLIN studied mathematics at Cambridge (MA 1972) and Oxford (MSc 1973, DPhil 1975) and trained as an actuary (FFA 1978) while working in a life insurance company. He moved to the City in 1980 and has worked for major banks (including HSBC, Nomura International, and ABN AMRO). As a partner in Reoch Credit he has consulted to law firms, hedge funds, corporate treasurers, institutional investment funds and risk control departments of major banks in the areas of credit and mortality risk. He has been involved in the credit derivatives market since 1996 and life settlements structures since 2003. Geoff has also maintained strong academic interests – he was a visiting (emeritus) professor at the University of Waterloo, Canada, from 1987 until 1999. He has also published many articles in Risk, the Journal of the Institute and Faculty of Actuaries, and others, speaks regularly at conferences and is the author of Credit Derivatives: Risk management, Trading and Investing (John Wiley & Sons Ltd, 2005) and co-author of Life Settlements and Longevity Structures: Pricing and Risk Management: Investment and Structured Finance (John Wiley & Sons Ltd, 2009).
Preface to the First Edition.

Preface to the Second Edition.



Table of Spreadsheet Examples and Software.

About the Author.


1 Credit Debt and Other Traditional Credit Instruments.

1.1 Bonds and Loans; Libor Rates and Swaps; 'REPO' and General Collateral Rates.

1.2 Credit Debt Versus 'Risk-Free' Debt.

1.3 Issue Documents, Seniority and the Recovery Process.

1.4 Valuation, Yield and Spread.

1.5 Buying Risk.

1.6 Marking to Market, Marking to Model and Reserves.

1.7 The ‘Credit Crunch’ and Correlation.

1.8 Parties Involved in the Credit Markets and Key Terminology.

2 Default and Recovery Data; Transition Matrices; Historical Pricing.

2.1 Recovery: Ultimate and Market-Value-Based Recovery.

2.2 Default Rates: Rating and Other Factors.

2.3 Transition Matrices.

2.4 'Measures' and Transition Matrix-Based Pricing.

2.5 Spread Jumps and Spread Volatility Derived from Transition Matrices.

2.6 Adjusting Transition Matrices.

3 Asset Swaps and Asset Swap Spread; z-Spread.

3.1 'Par–Par' Asset Swap Contracts.

3.2 Asset Swap Spread.

3.3 Maturity and z-Spread.

3.4 Callable Asset Swaps; 'Perfect' Asset Swaps.

3.5 A Bond Spread Model.

4 Liquidity, the Credit Pyramid and Market Data.

4.1 Bond Liquidity.

4.2 The Credit Pyramid.

4.3 Engineered and Survey Data.

4.4 Spread and Rating.

5 Traditional Counterparty Risk Management.

5.1 Vetting.

5.2 Collateralisation and Netting.

5.3 Additional Counterparty Requirements for Credit Derivative Counterparties.

5.4 Internal Capital Charge.

6 Credit Portfolios and Portfolio Risk.

6.1 VaR and counterpartyVaR.

6.2 Distribution of Forward Values of a Credit Bond.

6.3 Correlation and the Multi-Factor Normal (Gaussian) Distribution.

6.4 Correlation and the Correlation Matrix.

7 Introduction to Credit Derivatives.

7.1 Products and Users.

7.2 Market Participants and Market Growth.


8 Credit Default Swaps; Product Description and Simple Applications.

8.1 CDS Product Definition.

8.2 Documentation.

8.3 Credit Triggers for Credit Derivatives.

8.4 CDS Applications and Elementary Strategies.

8.5 Counterparty Risk: PFE for CDS.

8.6 CDS Trading Desk.

8.7 CDS Contract and Convention Changes 2009.

9 Valuation and Risk: Basic Concepts and the Default and Recovery Model.

9.1 The Fundamental Credit Arbitrage – Repo Cost.

9.2 Default and Recovery Model; Claim Amount.

9.3 Deterministic Default Rate Model.

9.4 Stochastic Default Rate Model; Hazard and Pseudo-Hazard Rates.

9.5 Calibration to Market Data.

9.6 CDS Data/Sources.

9.7 Model Errors and Tests.

9.8 CDS Risk Factors; Reserves and Model Risk.

10 CDS Deal Examples.

10.1 A CDS Hedged Against Another CDS.

10.2 Introduction to Bond Hedging.

10.3 Hedge and Credit Event Examples.

11 CDS/Bond Basis Trading.

11.1 Bond Versus CDS: Liquidity.

11.2 Bond Repo Cost.

11.3 Bond Spread Measurement – z-Spread not Asset Swap Spread.

11.4 Bond Price Impact.

11.5 Embedded Options in Bonds and Loans.

11.6 Delivery Option in CDSs.

11.7 Payoff of Par.

11.8 Trigger Event Differences.

11.9 Embedded Repo Option.

11.10 Putting it All Together.

12 Forward CDS; Back-to-Back CDS, Mark to Market and CDS Unwind.

12.1 Forward CDS.

12.2 Mark-to-Market and Back-to-Back CDS.

12.3 Unwind Calculation; Off-Market Trade Valuation and Hedging.

12.4 'Double-Trigger CDS'.

13 Credit-Linked Notes.

13.1 CLN Set-Up; Counterparty or Collateral Risk.

13.2 Embedded Swaps and Options.

13.3 Costs.

13.4 Applications.

13.5 CLN Pricing.

13.6 Capital Guaranteed Note.

14 Digital or 'Fixed Recovery' CDS.

14.1 Product Description.

14.2 Pricing, Hedging, Valuation and Risk Calculations.

14.3 Trigger Event Differences.

15 Spread Options, Callable/Puttable Bonds, Callable Asset Swaps, Callable Default Swaps.

15.1 Product Definitions.

15.2 Model Alternatives and a Stochastic Default Rate Model for Spread Option Pricing.

15.3 Sensitivities and Hedging.

16 Total Return Swaps.

16.1 Product Definition and Examples.

16.2 Applications.

16.3 Hedging and Valuation.

17 Single Name Book Management.

17.1 Risk Aggregation.

17.2 CreditVaR for CDSs.

18 CDS and Simulation.

18.1 The Poisson Model and Default Times.

18.2 Valuation by Monte Carlo Simulation.

18.3 Sensitivity.


19 Portfolio Product Types.

19.1 Nth-to-Default Baskets.

19.2 'Synthetic' CDOs.

19.3 Cashflow CDOs.

19.4 Credit Securitisations.

19.5 Rating.

19.6 Alternative Levered Credit Portfolio Products.

20 The Normal Copula and Correlation.

20.1 Default Time Correlation.

20.2 Normal Copula.

20.3 Correlation.

21 Correlation in Practice.

21.1 Tranche Correlation.

21.2 Base Correlation.

21.3 Correlated Recoveries.

21.4 Correlation Regime Change and Other Modelling Approaches.

22 Valuation and Hedging.

22.1 Valuation Examples.

22.2 Sensitivity Calculation and Hedging.

22.3 Pricing More Complex Structures.

22.4 Model Errors and Tests; Alternative Models.

23 Alternative Copulas.

23.1 Student’s t-Distribution.

23.2 Copulas in General.

23.3 Archimedean Copulas: Clayton, Gumbel.

23.4 Clayton at ¸ = 0 and ¸ = ∞.

23.5 Model Risk.

24 Correlation Portfolio Management.

24.1 Static and Dynamic Hedges.

24.2 Correlation Book Management.

24.3 CreditVaR and CounterpartyVaR.


25 Single Name CDS.

25.1 Non-Correlated Counterparty.

25.2 100% Correlation.

25.3 Correlated Counterparty: Pricing and Hedging.

25.4 Choice of Copula.

25.5 Collateralised Deals and CDS Book Management.

26 Counterparty CDSs.

26.1 Pricing.

26.2 Counterparty CDS (CCDS) Book Management.


27 Mathematical Model and Systems Validation.

27.1 Testing Procedures.

27.2 Implementation and Documentation.

28 System Implementation.

28.1 Anatomy of a CDO.

28.2 Management.

28.3 Valuation.

28.4 IT Considerations.


29 Cause and Effect: Credit Derivatives and the Crisis of 2007.

29.1 The Credit Markets Pre-Crisis.

29.2 The Events of MID-2007.

29.3 Issues to be Addressed.

29.4 Market Clearing Mechanisms.

Appendix Markit Credit and Loan Indices.