Chapter 7: Common Contracts 317
also risk of default. It is common to make risk of default
depend on the asset value, so the lower the stock price the
greater the probability of default.
Credit Default Swap (CDS) is a contract used as insurance
against a credit event. One party pays interest to another for
a prescribed time or until default of the underlying instrument.
In the event of default the counterparty then pays the princi-
pal in return. The CDS is the dominant credit derivative in the
structured credit market. The premium is usually paid period-
ically (quoted in basis points per notional). Premium can be
an up-front payment, for short-term protection. On the credit
event, settlement may be the delivery of the reference asset in
exchange for the contingent payment or settlement may be in
cash (that is, value of the instrument before default less value
after, recovery value). The mark-to-market value of the CDS
depends on changes in credit spreads. Therefore they can be
used to get exposure to or hedge against changes in credit
spreads. To price these contracts one needs a model for risk
of default. However, commonly, one backs out an implied risk
of default from the prices of traded CDSs.
Diff(erential) swap is an interest rate swap of floating for fixed
or floating, where one of the floating legs is a foreign inter-
est rate. The exchange of payments are defined in terms of a
domestic notional. Thus there is a quanto aspect to this instru-
ment. One must model interest rates and the exchange rate,
and as with quantos generally, the correlation is important.
Digital option is the same as a binary option.
Extendible option/swap is a contract that can have its ex-
piration date extended. The decision to extend may be at
the control of the writer, the holder or both. If the holder has
the right to extend the expiration then it may add value to
the contract, but if the writer can extend the expiry it may
decrease the value. There may or may not be an additional
premium to pay when the expiration is extended. These con-
tracts are best valued by finite-difference means because the
contract contains a decision feature.
Floating Rate Note (FRN) is a bond with coupons linked to a
variable interest rate issued by a company. The coupon will