TAILIEUCHUNG - A Beginner's Guide to Credit Derivatives 

Forecasting credit portfolio risk poses a challenge for the banking industry. One important goal of modern credit portfolio models is the forecast of the future credit risk given the information which is available at the point of time the forecast is made. Thus, the discussion paper “Forecasting Credit Portfolio Risk“ proposes a dynamic concept for the forecast of the risk parameters default probabilities and default correlations. The results are based on an extensive empirical analysis of a data set provided by Deutsche Bundesbank which contains financial statements for more than 50,000 German firms and a time period from 1987 to 2000 | A Beginner s Guide to Credit Derivatives Noel Vaillant Debt Market Exotics Nomura International November 17 2001 Contents 1 Introduction 2 2 Trading Strategies and Replication 4 Contingent Claims. 4 Stochastic Processes. 5 Tradable Instruments and Trading Strategies. 7 The Wealth Process . 8 Replication and Non-Arbitrage Pricing. 11 3 Credit Contingent Claims 14 Collapsing Numeraire . 14 Delayed Risky Zero. 16 Credit Default Swap. 18 Risky Floating Payment and Related Claim. 19 Foreign Credit Default Swap . 21 Equity Option with Possible Bankruptcy. 23 Risky Swaption and Delayed Risky Swaption . 25 OTC Transaction with Possible Default. 29 A Appendix 32 SDE for Cash-Tradable Asset and one Numeraire . 32 SDE for Futures-Tradable Asset and one Numeraire . 33 SDE for Funded Asset and one Numeraire . 34 SDE for Funded Asset and one Collapsing Numeraire . 34 SDE for Collapsing Asset and Numeraire . 36 Change of Measure and New SDE for Risky Swaption . 37 I am greatly indebted to my colleagues Evan Jones and Kevin Sinclair for their valuable comments and recommendations. 1 1 Introduction This document will attempt to describe how simple credit derivatives can be formally represented shown to be replicable and ultimately priced using reasonable assumptions. It is a beginner s guide on more than one count its subject matter is limited to the most simple types of claims those involved in credit default swaps plus a few more and its treatment so detailed that most beginners should be able to follow it. Basic definitions of general option pricing are also included to establish a common and consistent terminology and to avoid any possible misunderstanding. It is also a beginner s guide in the sense that I am myself a complete beginner on the subject of credit. I have no trading experience of credit default swaps and my modeling background is limited to that of the default-free world. When I became .

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