3.4.Hull Ch 23

Insurance against a default by a particular company on a particular issuance of debt. It involves periodic pmt by the party purchasing the ins and, in the event of default, a pmt by the seller

• Reference entity: entity whose credit rating is being protected
• Reference obligation: bond used to monitor wheter a credit event occurs and to determine swap payoff
• Notional principal: par value of the reference obligation
• Credit event: default (could be default of other obligations)

• CDS Spread = pmt rate such that PV(buyer) = PV(seller)
• Step 1: determine unconditional default probability
• Step 2: determine buyer's pmts (annual spread and accrual pmt when default occurs)
• Step 3: determine seller's pmt
• Step 4: solve for spread, s

• CDX NA IG and iTraxx Europe
• Both are PF of 125 investment grade

Objective of CDO is largely to transfer credit risk → no need to contain actual bonds (only credit default swaps). In that case we call it a synthetic CDO