Contingent credit default swaps

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EM LYON School of Management

FINAL THESIS Contingent Credit Default Swaps: How to Manage Contingent Credit Risk

Sika Jean Angbonou

Page 0

EM LYON School of Management

Table of Contents

I. II. A. B. III. A. B.

INTRODUCTION ............................................................................................................................................. 2PRELIMINARIES ............................................................................................................................................. 3 BASICS AND OVERVIEW ..........................................................................................................................................3 C-CDS SETTLEMENT MECHANICS.............................................................................................................................5 VALUATION OF CREDIT DEFAULT SWAP ........................................................................................................ 7 GENERAL VALUATION .............................................................................................................................................7APPROXIMATION FROM DEFAULT PROBABILITIES .........................................................................................................8 1. Valuation of the Fee Leg...............................................................................................................................9 2. Valuation of the Contingent Leg..................................................................................................................9 3. From Hazard Rate to Default Probabilities ................................................................................................10 VALUATION OF COUNTERPARTY RISK ..................................................................................................... 11 THE PROBABILISTIC FRAMEWORK...........................................................................................................................12 GENERAL FORMULA .............................................................................................................................................12 COUNTERPARTY RISK IN SINGLE INTEREST RATE SWAP............................................................................... 14 A. B. C. INTEREST RATE SWAP (IRS) ...................................................................................................................................14 VALUATION OF INTEREST RATE SWAP ......................................................................................................................15 COUNTERPARTY RISK IN IRS VALUATION..................................................................................................................16 CONTINGENT CDS UNDER CORRELATION BETWEEN INTEREST-RATES AND DEFAULT .............................. 18 1. 2.

IV. A. B. V.

VI. A.

MATHEMATICS TOOLS..........................................................................................................................................18 Generating two sequences of correlated random numbers .......................................................................18 Mean Reversion Process .............................................................................................................................18 B. MODELING ASSUMPTIONS....................................................................................................................................20 1. CDS Calibration...........................................................................................................................................21 2. CCDS Pricing ...............................................................................................................................................21 C....
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