22-Credit Risk Model Derivs Page 679 Wednesday, February 4, 2004 1:12 PM

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CHAPTER

22

Credit Risk Modeling and

Credit Default Swaps*

n Chapter 2, we described the different forms of credit risk–default risk,

credit spread risk, and downgrade risk. Credit derivatives are financial

instruments that are designed to transfer the credit risk exposure of an

underlying asset or assets between two parties. With credit derivatives,

market participants can either acquire or reduce credit risk exposure. The

ability to transfer credit risk and return provides a new tool for market par-

ticipants to improve performance. Using credit derivatives, banks may sell

concentrated credit risks in their portfolios while keeping the loans of their

customers on their books; these loans are otherwise not transferable due to

relationship management issues or due to legal agreements. Credit deriva-

tives include credit default swaps, asset swaps, total return swaps, credit

linked notes, credit spread options, and credit spread forwards.^1 By far the

most popular credit derivatives is the credit default swap. In this chapter we

describe credit risk modeling and the valuation of credit default swaps. We

begin with a discussion of the basic features of credit default swaps.

CREDIT DEFAULT SWAPS

In a credit default swap, the documentation will identify the reference

entity or the reference obligation. The reference entity is the issuer of

(^1) For a discussion of each of these credit derivatives, see Mark J.P. Anson, Frank J.
Fabozzi, Moorad Choudhry, and Ren-Raw Chen, Credit Derivatives: Instruments,
Applications, and Pricing (Hoboken, NJ: John Wiley & Sons, 2003).

• This chapter is coauthored with Professor Ren-Raw Chen of Rutgers University.
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