The credit derivatives industry has come under close scrutiny over
the past few years, with the recent financial crisis highlighting
the instability of a number of credit structures and throwing the
industry into turmoil. What has been made clear by recent events is
the necessity for a thorough understanding of credit derivatives by
all parties involved in a transaction, especially traders,
structurers, quants and investors.

Fully revised and updated to take in to account the new
products, markets and risk requirements post financial crisis,
Credit Derivatives: Trading, Investing and Risk Management,
Second Edition, covers the subject from a real world
perspective, tackling issues such as liquidity, poor data, and
credit spreads, to the latest innovations in portfolio products,
hedging and risk management techniques.

The book concentrates on practical issues and develops an
understanding of the products through applications and detailed
analysis of the risks and alternative means of trading.

It provides:

* a description of the key products, applications, and an
analysis of typical trades including basis trading, hedging, and
credit structuring;

* analysis of the industry standard 'default and recovery' and
Copula models including many examples, and a description of the
models' shortcomings;

* tools and techniques for the management of a portfolio or book
of credit risks including appropriate and inappropriate methods of
correlation risk management;

* a thorough analysis of counterparty risk;

* an intuitive understanding of credit correlation in reality and
in the Copula model.

The book is thoroughly updated to reflect the changes the
industry has seen over the past 5 years, notably with an analysis
of the lead up and causes of the credit crisis. It contains 50% new
material, which includes copula valuation and hedging, portfolio
optimisation, portfolio products and correlation risk management,
pricing in illiquid environments, chapters on the evolution of
credit management systems, the credit meltdown and new chapters on
the implementation and testing of credit derivative models and
systems.

The book is accompanied by a website which contains tools
for credit derivatives valuation and risk management, illustrating
the models used in the book and also providing a valuation
toolkit.

GEOFF CHAPLIN studied mathematics at Cambridge (MA 1972) and Oxford (MSc 1973, DPhil 1975) and trained as an actuary (FFA 1978) while working in a life insurance company. He moved to the City in 1980 and has worked for major banks (including HSBC, Nomura International, and ABN AMRO). As a partner in Reoch Credit he has consulted to law firms, hedge funds, corporate treasurers, institutional investment funds and risk control departments of major banks in the areas of credit and mortality risk. He has been involved in the credit derivatives market since 1996 and life settlements structures since 2003. Geoff has also maintained strong academic interests - he was a visiting (emeritus) professor at the University of Waterloo, Canada, from 1987 until 1999. He has also published many articles in Risk, the Journal of the Institute and Faculty of Actuaries, and others, speaks regularly at conferences and is the author of Credit Derivatives: Risk Management, Trading and Investing (John Wiley & Sons Ltd, 2005) and co-author of Life Settlements and Longevity Structures: Pricing and Risk Management: Investment and Structured Finance (John Wiley & Sons Ltd, 2009).

The credit derivatives industry has come under close scrutiny over the past few years, with the recent financial crisis highlighting the instability of a number of credit structures and throwing the industry into turmoil. What has been made clear by recent events is the necessity for a thorough understanding of credit derivatives by all parties involved in a transaction, especially traders, structurers, quants and investors.

Fully revised and updated to take in to account the new products, markets and risk requirements post financial crisis, Credit Derivatives: Trading, Investing and Risk Management, Second Edition, covers the subject from a real world perspective, tackling issues such as liquidity, poor data, and credit spreads, to the latest innovations in portfolio products, hedging and risk management techniques.

The book concentrates on practical issues and develops an understanding of the products through applications and detailed analysis of the risks and alternative means of trading. It provides:

• a description of the key products, applications, and an analysis of typical trades including basis trading, hedging, and credit structuring;
• analysis of the industry standard 'default and recovery' and Copula models including many examples, and a description of the models' shortcomings;
• tools and techniques for the management of a portfolio or book of credit risks including appropriate and inappropriate methods of correlation risk management;
• a thorough analysis of counterparty risk;
• an intuitive understanding of credit correlation in reality and in the Copula model.

The book is thoroughly updated to reflect the changes the industry has seen over the past 5 years, notably with an analysis of the lead up and causes of the credit crisis. It contains 50% new material, which includes copula valuation and hedging, portfolio optimisation, portfolio products and correlation risk management, pricing in illiquid environments, chapters on the evolution of credit management systems, the credit meltdown and new chapters on the implementation and testing of credit derivative models and systems. The book is accompanied by a website which contains tools for credit derivatives valuation and risk management, illustrating the models used in the book and also providing a valuation toolkit.

Preface to the First Edition xvii

Preface to the Second Edition xix

Acknowledgements xxi

Disclaimer xxiii

Table of Spreadsheet Examples and Software xxvii

About the Author xxix

Part I Credit Background and Credit Derivatives 1

1 Credit Debt and Other Traditional Credit Instruments 3

1.1 Bonds and Loans; Libor Rates and Swaps; 'REPO' and General Collateral Rates 3

1.1.1 Bonds and Loans 3

1.1.2 BBA Libor and Swaps 4

1.1.3 Collateralised Lending and Repo 4

1.1.4 Repo as a Credit Derivative 6

1.2 Credit Debt Versus 'Risk-Free' Debt 6

1.3 Issue Documents, Seniority and the Recovery Process 6

1.3.1 Issue Documents and Default 6

1.3.2 Claim Amount 7

1.3.3 The Recovery Process and Recovery Amount 8

1.3.4 Sovereign versus Corporate Debt 9

1.4 Valuation, Yield and Spread 10

1.5 Buying Risk 10

1.6 Marking to Market, Marking to Model and Reserves 11

1.7 The 'Credit Crunch' and Correlation 12

1.8 Parties Involved in the Credit Markets and Key Terminology 13

2 Default and Recovery Data; Transition Matrices; Historical Pricing 15

2.1 Recovery: Ultimate and Market-Value-Based Recovery 15

2.1.1 Ultimate Recovery 15

2.1.2 Market Recovery 16

2.1.3 Recovery Rates and Industry Sector 18

2.1.4 Recovery and Default Rates and the Economic Cycle 18

2.1.5 Modelling Recovery Rates 18

2.2 Default Rates: Rating and Other Factors 21

2.3 Transition Matrices 21

2.4 'Measures' and Transition Matrix-Based Pricing 22

2.5 Spread Jumps and Spread Volatility Derived from Transition Matrices 26

2.6 Adjusting Transition Matrices 27

3 As…