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Credit Derivatives

In: Handbook of the Economics of Finance

Author

Listed:
  • Hull, John
  • White, Alan

Abstract

This chapter explains how the main types of credit derivatives work and how they are valued. Central to the valuation of credit derivatives is an estimation of the probability that reference entities will default. The chapter discusses both the risk-neutral probabilities of default implied from credit spreads and the real-world (physical) default probabilities calculated from historical data, such as that provided by rating agencies. The academic literature attempting to explain the difference between these two probability estimates is summarized. The characteristics of credit default swaps, which are the most common type of single-name derivatives, are discussed, and procedures used to determine the contract values are explained. A similar presentation is provided for collateralized debt obligations, which are the most common type of multi-name credit derivatives. The chapter ends with a discussion of the economics of the collateralized debt obligation market and the role that these products played in the US financial crisis, which started in 2007.

Suggested Citation

  • Hull, John & White, Alan, 2013. "Credit Derivatives," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1363-1396, Elsevier.
    • Handle: RePEc:eee:finchp:2-b-1363-1396
    DOI: 10.1016/B978-0-44-459406-8.00020-2
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    References listed on IDEAS

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    1. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    2. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Altman, Edward I, 1989. " Measuring Corporate Bond Mortality and Performance," Journal of Finance, American Finance Association, vol. 44(4), pages 909-922, September.
    5. Jean-Paul Laurent & Jon Gregory, 2005. "Basket default swaps, CDOs and factor copulas," Post-Print hal-03679517, HAL.
    6. Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," The Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
    7. Edwin J. Elton & Martin J. Gruber & Deepak Agrawal & Christopher Mann, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, February.
    8. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," The Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
    9. Fons, Jerome S, 1987. "The Default Premium and Corporate Bond Experience," Journal of Finance, American Finance Association, vol. 42(1), pages 81-97, March.
    10. Pierre Collin-Dufresn & Robert S. Goldstein & J. Spencer Martin, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
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    Cited by:

    1. Han, Meng & He, Yeqi & Zhang, Hu, 2013. "A Note on Discounting and Funding Value Adjustments for Derivatives," MPRA Paper 44495, University Library of Munich, Germany.
    2. Heaton, J.B., 2018. "Risk aversion as risk-neutral pessimism: A simple proof," International Review of Law and Economics, Elsevier, vol. 56(C), pages 70-72.
    3. Hunzinger, Chadd B. & Labuschagne, Coenraad C.A., 2014. "The Cox, Ross and Rubinstein tree model which includes counterparty credit risk and funding costs," The North American Journal of Economics and Finance, Elsevier, vol. 29(C), pages 200-217.

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