22-Credit Risk Model Derivs Page 735 Wednesday, February 4, 2004 1:12 PM
Credit Risk Modeling and Credit Default Swaps 735■ Credit default swaps for corporate and sovereign reference entities are
standardized.
■ The International Swaps and Derivatives Association (ISDA) developed
the ISDA Master Agreement which establishes international standards
governing privately negotiated derivative trades (all derivatives).
■ The 1999 ISDA Credit Derivatives Definitions provides a list of eight
possible credit events.
■ Credit derivative models can be partitioned into structural models and
reduced form models.
■ Structural-type models represent default as an option: a company
defaults on its debt if the value of the assets of the company falls below
a certain default point.
■ Reduced form models model directly the likelihood of default or down-
grade.
■ Structural models use option theory.
■ Structural models model default on very reasonable assumption but are
difficult to calibrate and computationally burdensome.
■ Structural models use Poisson processes to model the time of default.
■ A transition matrix defines the probability of transition between any
two credit rating states.
■ Default correlation is a concept difficult to define.
■ Default correlation can be modeled with copula functions that model
the correlation between the times of default.