Chapter 26

American credit options are credit options that can be exercised prior to or at expiration.

A novation or an assignment is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.

Binary options (sometimes termed digital options) offer only two possible payouts, usually zero and some other fixed value.

To calibrate a model means to establish values for the key parameters in a model, such as a default probability or an asset volatility, typically using an analysis of market prices of highly liquid assets.

In a cash settlement, the credit protection seller makes the credit protection buyer whole by transferring to the buyer an amount of cash based on the contract.

CDS indices are indices or portfolios of single-name CDSs.

The CDS spread or CDS premium is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.

The CDS spread or CDS premium is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.

A credit default swap (CDS) is an insurance-like bilateral contract in which the buyer pays a periodic fee (analogous to an insurance premium) to the seller in exchange for a contingent payment from the seller if a credit event occurs with respect to an underlying credit-risky asset.

Credit derivatives transfer credit risk from one party to another such that both parties view themselves as having an improved position as a result of the derivative.

In a CDS, the credit protection buyer pays a periodic premium on a predetermined amount (the notional amount) in exchange for a contingent payment from the credit protection seller if a specified credit event occurs.

The credit protection seller receives a periodic premium in exchange for delivering a contingent payment to the credit protection buyer if a specified credit event occurs.

Credit risk is dispersion in financial outcomes associated with the failure or potential failure of a counterparty to fulfill its financial obligations.

Credit-linked notes (CLNs) are bonds issued by one entity with an embedded credit option on one or more other entites.

Default risk is the risk that the issuer of a bond or the debtor on a loan will not repay the interest and principal payments of the outstanding debt in full.

Derivtives are cost-effective vehicles for the transfer of risk, with values driven by an underlying asset.

European credit options are credit options exercisable only at expiration.

Exposure at default (EAD) specifies the nominal value of the position that is exposed to default at the time of default.

Funded credit derivatives require cash outlays and create exposures similar to those gained from traditional investing in corporate bonds through the cash market.

Hazard rate is a term often used in the context of reduced-form models to denote the default rate.

Loss given default (LGD) specifies the economic loss in case of default.

The process of altering the value of a CDS in the accounting and financial systems of the CDS parties is known as a mark-to-market adjustment.

Multiname instruments, in contrast to single-name instruments, make payoffs that are contingent on one or more credit events (e.g., defaults) affecting two or more reference entities.

A novation or an assignment is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.

Under physical settlement, the credit protection seller purchases the impaired loan or bond from the credit protection buyer at par value.

Price revelation, or price discovery, is the process of providing observable prices being used or offered by informed buyers and sellers.

Probability of default (PD) specifies the probability that the counterparty fails to meet its obligations.

The recovery rate is the percentage of the credit exposure that the lender ultimately receives through the bankruptcy process and all available remedies.

Reduced-form credit models focus on default probabilities based on observations of market data of similar-risk securities.

The referenced asset (also called the referenced bond, referenced obligation, or referenced credit) is the underlying security on which the credit protection is provided.

A risk-neutral approach models financial characteristics, such as asset prices, within a framework that assumes that investors are risk neutral.

A risk-neutral investor is an investor that requires the same rate of return on all investments, regardless of levels and types of risk, because the investor is indifferent with regard to how much risk is borne.

Single-name credit derivatives transfer the credit risk associated with a single entity. This is the most common type of credit derivative and can be used to build more complex credit derivatives.

The standard ISDA agreement serves as a template to negotiated credit agreements that contains commonly used provisions used by market participants.

In a total return swap, the credit protection buyer, typically the owner of the credit risky asset, passes on the total return of the asset to the credit protection seller in return for a certain payment.

Unfunded credit derivatives involve exchanges of payments that are tied to a notional amount, but the notional amount does not change hands until a default occurs.