Advanced Derivatives HPU

Syllabus Advanced Derivatives
Course: Fin3610/6610: Exploring New Boundaries in Derivatives
Professor: Dr. Gunter Meissner

E-mail: gmeissne@aol.com
Office: FHT 1, Tel: 544 0807
Web: www.dersoft.com
Description: The course focuses on RESEARCH. Each student will choose a topic in the
derivatives area and become an expert in that area. The student will together with the
Professor derive new results in the specific area. Every 3 weeks, the student will give a
presentation about the progress of his/her research.
Generally, the course will cover new developments in the theory and application of
Futures, Swaps and Options. It will analyze the valuation and risk of exotic
derivatives as well as focus on the practical application of new derivatives as
credit derivatives in debt management, portfolio management, and risk-management.
Syllabus Advanced Derivatives
Goals: To obtain a complete overview of new derivatives
To understand the valuation and risk calculation of new derivatives.
To develop the ability to use exotic derivatives as a risk management and cost
reduction tool
To make each student an expert in a certain area to get him a cool job in the
derivatives area.
Requirements: A fairly strong mathematical/statistical background is necessary for this
course.
Literature: 1) Trading Financial Derivatives, Gunter Meissner

2) Slides on www.dersoft.com/hpu
3) Credit Derivatives: Application, Pricing and Risk Management,
Gunter Meissner
Optional:
4) Outperforming the Dow: Using Options, Futures and Portfolio
Strategies to Beat the Market, Gunter Meissner
5) RISK magazine (available at Library desk)
Grading: Attendance and Participation 10%

Project 50%
Presentation of the project 10%
Final exam 30%
For fall 2007:
Sources:
www.dersoft.com/outlineCDObook.doc
www.dersoft.com/presGARPCDO.ppt
www.dersoft.com/ofgc.doc
www.dersoft.com/cdoapplication.doc
(research assistant needed)
Contents in Detail
Lecture 1: The Mathematical foundation of Derivatives Pricing (Generalized Wiener

Process, Geometric Brownian Motion, Random Walk, Markov Property,
Martingale, Risk-Neutrality, Market price of risk, Completeness, Copulas)
Lecture 2: Black-Scholes revisited: Assumptions, Concept, Criticism (Distribution,

Volatility smile, tails)
Lecture 3: Standard exotic Options (Digitals, Barriers, Lookbacks, Average options)
Lecture 4: Standard exotic Options continued (Compound options, Choosers,

Multi-asset Options, Convertibles)
Lecture 5: Basic Swaps (Interest Rate Swaps, Cross-Currency Swaps, Equity Swaps,
Asset Swaps – Application, Pricing, Programming, Risk Management)
Lecture 6: Exotic Swaps (Yield curve swaps, Libor in arrears swaps, Differential swaps,
Index principal swaps - Application, Pricing, Programming, Risk Management)
Lecture 7: Midterm
Contents in Detail cont.
Lecture 8: Introduction to Credit Derivatives (The Market, the Products, Relationship

between products, Relationship to cash products)
Lecture 9: The Application of Credit Derivatives (Hedging, Speculation,

Arbitrage, Cost-reduction/Convenience, Regulatory Capital Relief)
Lecture 10: Synthetic Structures (CLNs, CDOs (Cash, Synthetic), TPDS,

TBDSs, Libor2, Single Tranche CDOs)
Lecture 11: Quantifying Credit Risk (Jarrow-Turnbull 1995, Jarrow-Lando-

Turnbull 1997)
Lecture 12: Quantifying Credit Risk cont. (Duffie-Singleton 1999, Hull-White

2001, Kettunen-Ksendovsky-Meissner 2003)
Lecture 13: Modern Risk Management: Hedging individual Risks (Market Risk,
Credit Risk, Operational Risk) with Market and Credit Derivatives
Lecture 14: Portfolio Risk Management : Managing VAR, CAR, and OPVAR with
Market and Credit Derivatives
Lecture 15: Final

Project Topics
1) Is credit risk lognormally distributed? An empirical study
2) Robert Engle (Nobel Prize winner 2004) and his
Dynamic Conditional Correlation (DCC) Model (based on GARCH)
3) Operational Risk Management – The next Generation
4) New Developments in Synthetic Structures (Chapter 3)
5 ) Latest Models in Pricing Credit Derivatives (Chapter 5; Math Topic)
6) New developments in the Risk-Management

VAR (value at risk) concept, CAR (credit at risk) concept (Chapter 6)
7) Default Contingencies (Jarrow Turnbull 1995, footnote 8)
8) Analyze default correlations
9) Basel II – Latest Developments
10) The latest Hedge Fund Strategies – example Northwater Capital
11) The Credit Derivatives Market - Latest Product Innovations as
Options on DS; CMDS (Constant Maturity Default Swaps)
12) Survey of Credit Derivatives venders
13) How to value employee stock options; Should they be expensed?
Project Topics
14) New developments in Weather Derivatives and programming the major products
15) Euro Overnight Index Average Swaps (Eonia), programming them
16) Survey of existing derivatives pricing and risk-management software
17) Hot bond issues including derivatives, creating new bond-structures
18) Newest exotics and programming them
19) New Developments in Volatility swaps, programming them
20) Double Average Rate Option (Daros), programming them
21) Convertibles, programming them
22) Term structures based models - Understanding them, programming the LMM
and/or creating a new one
23) “Real Options” – A useful Approach? (KMV credit risk model)
24) The default swap premium: Difference in up-front payment and periodic payment
25) Real Estate Derivatives – A new market with potential?
26) Latest Developments in Stochastic Volatility
27) Volatility of Volatility – A Valuable Trading Indicator?
28) Copulas – Concept, Types, Application in joint credit risk valuation
29) Recovery Rate : What determines it? What is the correlation to Default Prob?
30) Equity Default Swaps – Relationship to CDS, Pricing and Application
31) Correlation Trading – Pricing, Opportunities and Threats
Project Topics
32) Combining Structural and Reduced Form Models – An attempt
33) Combining Market risk (interest rate risk) and Credit risk
34) The Omega function – A breakthrough?
35) Trading Credit Derivatives on an exchange – Requirements, Promising?
36) The CDX, iTraxx and other CDS indexes - Composition, Trading
37) Liquidity risk – Understanding constraints and pitfalls
38) The geometric Brownian motion – A reasonable foundation of derivatives
pricing? Alternatives?
39) Stochastic Vol models; local Vol models
40) Deriving base correlation from tranche implied correlation (includes
programming a VBA model) (will be mentioned in OFGC chapter)
41) Approaches to generate the Loss Distribution
42) The CDO market – Status quo of a crash, Outlook
43) Implementing Gaussian quadrature to value CDOs

44) The Credit Derivatives Revolution (to be published in RISK Review,
November 2007) update chapter 1 in “Credit Derivatives”
research assistant/co-author(s) needed
Project Topics
45) Application of CDOs www.dersoft.com/cdoapplication.doc
(is chapter 2 in the book; research assistant needed)
46) Hedging CDOs (is chapter 6 in the book; research assistant needed),
see www.dersoft.com/outlineCDObook.doc chapter 6
see last slides on www.dersoft.com/presGARPCDO.ppt
47) CDOs and Model Validation (possible chapter for the book)
48) Rewriting Robert Engle’s (with Arthur Berd and Artem

Voronov) “The Underlying Dynamics of Credit Correlations”
49) Modeling non-normal CDO returns – The Omega Function

(is a chapter in the book, research assistant needed, gathering
CDO returns needed)
Jobs in the Derivatives Area
www.pacifica.co.jp numa.com financewise.com topmoneyjobs.com
www.gloriamundi.com www.garp.com
Of the S&P 500 companies, how many use Derivatives???
•Trader
•Marketer
•Risk Management (fast growing area); Fin3801/6801
•Product Developer (well paid)
•Structured Products
•Derivatives Controller
•Programmer
•Settlement
•Broker (Private Investor, Interbank)

Properties of Derivatives Pricing
It is typically assumed that the underlying instrument follows a
In a a variable (stock) grows with

an average drift rate μ. Superimposed on this growth rate is a
stochastic term, which adds volatility to the process:
dS = μ dt + σ dz
dS : change in the stock price S

 : drift rate, which is the expected stock return (price change + dividends)
dt : infinitely short time period
 : expected volatility of the stock price S
dz : ; dz = ε dt where ε is a random drawing from a standardized normal
distribution. All drawings are independent from each other
If the relative change of a variable follows a generalized Wiener process, this is typically referred to as a
geometric Brownian motion.
dS/S = μ dt + σ ε dt
The discrete version is
S/S = μ t + σ ε t
Example:
The present stock price is $100, next year's expected return is 15%, the annual expected
volatility is 30%. The sample drawing from a standardized normal distribution results in
+0.5.
What is the expected stock price in one day (=1/365) due to the geometric Brownian motion?
The one-day change of the stock is
Thus, the stock price after one day is assumed to be

Graphically the geometric Brownian motion looks as follows:
dS/S
Average growth
rate
What determines the ‘width’ of the distribution???
(See Excel sheet TRADE SMART/Options/Geometric Brownian Motion.xls)

The geometric Brownian motion can be easily programmed in Excel. We

can use equation
 12 
ε   R i   6
 i 1 
to find epsilon. R is a random number between 0 and 1 (Rand() in Excel)
See www.dersoft.com/geometric.xls
Critical appraisal of the geometric Brownian

motion:
• Captures the property of uncertainty
• Are stock price movements totally uncertain??
What about business cycles?
• Are the price movements of other commodities as

bonds, currencies, commodities, credit!, totally uncertain??
Since this stock price prediction is partly determined by a random drawing from a normal
distribution, this prediction methodology is called a process. If a price
follows a random walk process, this means that due to the random nature of the process,
principally no above market return trading strategy can be formulated.
This is consistent with the weak form of the which says that all
information about a stock is already incorporated in the current stock price. As a consequence, the past
information of a stock price is irrelevant and the future process of a stock price depends only on its
value at the beginning of the period..
This property is also referred to as the .This property denies the essential hypothesis
of technical analysis, which suggests that the future stock price can be derived from the past pattern
of the stock price.
If a generalized Wiener process has no drift rate, thus μ = 0, this is typically referred to as a
A martingale has the convenient property that the expected value E of a random variable X at
a future time t is equal to the current value of the variable: E(Xt) = X0.
Is a stock price a martingale?
Is a bond a martingale?
Is a zero-coupon bond a martingale?
Is roulette a martingale?
Is Black-Jack a martingale?
Derivatives Pricing assumes This means that
Investors
For example:
Investment A, the IBM stock has an expected return of 5% and an expected volatility of 20%.
Investment B, a call on Microsoft, has an expected return of 5% and a volatility of 50%.
Risk-neutrality implies that:
Since investors are risk-neutral, every asset is expected to grow with the
risk-free interest rate. If an asset is expected to grow with a higher rate,
investors will buy it and consequently reduce the return to the risk-free rate.
Are investors risk-neutral???
Bond prices actually overstate the probability of default significantly (are too
low) when compared to historical default probabilities as Altman 1989 pointed
out. This lets us conclude investors are rather risk-averse.
The reason for too low risky bond prices (compared to historical default
probabilities) also lies in the fact that investors consider
Systematic (non diversifiable) risk: In a future recession junk bonds will decline more
and are more likely to default !
• Lower liquidity of bond prices

Investment in the money market also grow with the risk-free interest rate r. A risky asset grows
with the expected return of the risky asset . The relationship between r and  was expressed first
by William Sharpe in his Nobel prize CAPM theory, created in 1960s.
Sharpe in his CAPM stated that an investor wants to be compensated for taking risk, the risk being
expressed as the volatility of the invested asset i, i. The compensation for the risk is reflected in the
excess return of the asset i, i - r:
i  r
i 
i
where  is the Sharpe ratio, often referred to as the
The expected growth rate of a stock is 15%, the volatility of the stock is 20%. The risk-free
interest rate is 5%. What is the market price of risk?
It is (15% - 5%) / 20% = 0.5
How does Sharp’s CAPM concept compare to the , which says that
the investors do not require compensation for taking risk and every asset grows
with the risk-free interest rate r (hence i = r)?
Black, Scholes and Merton found a famous partial differential equation (PDE) for valuing a
derivative D
D 1 D 1  2D 1 2 2
D  S  S
t r S 2 S 2 r
For every derivative that satisfies the PDE, a dynamic, self-financing trading strategy can
be created that replicates the derivative. (For example a long put can be replicated by
buying the delta amount of the underlying). This property is also referred to as
completeness. If a market is complete, going long the derivative and short the portfolio or
vice versa, is arbitrage-freefor small changes of the input parameters S, t, r, and σ
Also -arguably luckily- the variable μ drops out during the process of creating the PDE.
Therefore, no variable regarding the risk-preference of an investor is present.
Since risk preferences do not enter the PDE, they are also not part of the solution. Hence, any
set of risk preferences can be applied.
Hence the PDE and the satisfying Black-Scholes-Merton equation are valid not only in the
risk neutral world but
One equation that satisfies the PDE
D 1 D 1  2D 1 2 2
D  S  S
t r S 2 S 2 r
is the famous Black-Scholes equation. For a call:

C = S N(d1) - K e-rT N(d2)
where
d1 = S 1 and d2 = d1 -
ln(  rT
)  σ 2T σ T
Ke 2
σ T
Homework: Prove this for a put!

(Proof for a call is at www.dersoft.com/bsproof.doc)
Standard Exotics
Exotic options are options, whose payoff, valuation and

hedging procedures are different, usually more
complicated than those of a standard options.
Types of standard exotics:
· Digital options
· Barrier options
· Lookback options
· Average options
· Compound options
· Multi asset or correlation options
· Hybrids
(Book page 305)

Remember Black-Scholes?
 qT  rT
C  Se * N (d 1 )  K  e  N (d 2 )
q : continuously compounded, known return of the underlying asset
Se  qT 1 2
ln(  rT )   T
d1  Ke 2 d 2  d1   T
 T
C = f (S, K, r, q, T, )
(Book page 235)

Black-Scholes cont.
 rT  qT
P  K e  N ( d 2 )  S  e * N ( d 1 )
Se  qT 1 2 N (  d 2 )  1  N (d 2 )
ln(  rT )   T
d1  Ke 2 d 2  d1   T
 T N (  d 1 )  1  N (d 1 )
P = f (S, K, r, q, T, )
(Book p.236)
Normal versus log-normal distribution
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1 N(d)
0.05
0
d
-4 -3 -2 -1 0 1 2 3 4
(Book p.197)
Normal versus log-normal distribution, cont.
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4
(Book p.197)
Normal versus log-normal distribution, cont.
The log-normal distribution reflects the path a stock price takes over time!
S
E(ST )
t
T
((Book p.197))
Digital options
A digital option is an option, which pays a fixed amount of

cash (cash or nothing) or a fixed number of assets (asset
or nothing), if the option finishes in the money.
Digital options are also called binary or bet options.
There are two types of digital options:

•Cash or nothing digitals
•Asset or nothing digitals
(Book p.305)
Cash or nothing digital options
In a digital option, a fixed cash amount is paid regardless of how deep
the option finishes in the money. A cash or nothing call or cash or
nothing bull digital has a payoff of:
Example: The premium C = $50, Strike K = $100, Payoff if ST>K = 80:
Profit
Underlying price S
$100
Loss
A cash or nothing put, or cash or nothing bear digital has a

payoff of:
Example: The premium P = $50, Strike K = $100, Payoff if ST>K = 80:
Profit
$50
Underlying price S
$100
$30
Loss
The value function of a bull digital looks as follows:
The price function looks like the delta of a standard call!

(Book p.307)
Differentiating the price function, we get the delta:
The maximum of the delta is??
Is that a problem?
(Book p.307, 308)

Differentiating the delta, we get the gamma:
Features of the gamma are:
Is that a problem?
(Book p.307, 308)

The pricing of cash or nothing digitals is straightforward.

In chapter 7.2.1, we have concluded, that the probability of
an option finishing in the money is N(d2). Thus, a digital call
has a price of
CoN = PA e-rT N(d2)
A digital put has a price of
PA e-rT N(-d2).
(Book p.307, 308)

Asset or nothing digital options
Asset or nothing digitals pay a certain quantity of the asset, if
the option finishes in the money. The payoff therefore is
Example: C = $50, S = K = $100:
Profit
Underlying price S
Loss
(Book p.309)
Asset or nothing digital options
The payoff of a asset or nothing put is
Profit
}S - P Asset
P { price S
Loss
The price of an asset or nothing call is simply S * N(d1)

The price of an asset or nothing call is simply S * N(-d1)
(Book p.310)
Exotic options replicated through digitals
Contingent premium option
A contingent premium option is an option where the option

buyer pays the option premium at option maturity, only if
the option finishes in the money.
The option buyer has to exercise the option, if it finishes

in the money!
Thus , the option seller makes money, if the option

finishes slightly in the money.
(Book p.310)
The payoff of contingent premium call looks as follows:
The payoff of a contingent premium call can be replicated by adding

the payoff of a standard long call and a cash or nothing bear digital
(Book p.310,311)
The pricing formula for a contingent call is
S * N(d 1 )  e  rT * K * N (d 2 )
e  rT * N (d 2 )
For an at the money contingent call N(d2) is roughly 0.5. This

shows that at the money contingent calls are about twice as
expensive as standard calls.
This high price limits selling contingent calls to investors.
(Book p.310,311)
Exotic options replicated through digitals
Supershares
Supershares is a term used for a combination of options, which
try to mirror the market view of an investor as close as possible.
Profit
Asset
S1 S2 S3 price S
Loss
In the above graph, the investor is long a cash or nothing call with
strike S1, long a put digital with strike S2, and long a standard
call with strike S3.
(Book p.311,312)
Barrier options
A barrier option is an option, whose payoff depends not

only on the price of the underlying asset at maturity, but
also whether or not the underlying asset price reaches a
predefined barrier during the option period.
Types of barriers:
•Knock in and knock out options

•Inside and outside barriers exist
•American style barriers do not yet exist
(Book p.312,313)
Barrier options cont.
Eight types of barrier options exist
•Up and in call and put

•Up and out call and put
•Down and in call and put
•Down and out call and put
(Book p.313,314)
a) Up and In Call (Cui)
Payoff: max [0, ST - K] if St  KI
0 if StT < KI
S,K,KI
KI
ST
K
time
T
An up and in call, not being knocked in, so the payoff of a standard
call ST - K does not occur
Condition: K < KI, otherwise
(Book p.313,314)
b) Up and Out Call (Cuo)
Payoff: max [0, ST - K] if StT < KO
0 if St  KO
S,K,KI
Knock out
of option
KO
ST
K
time
T
An up and out call, being knocked out, so the payoff of a standard

call ST - K does not occur.
Condition: At option start t, S < KO also, K < KO
(Book p.314, 315)

c) Down and In Call (Cdi)
Payoff: max [0, ST - K] if St  KI
0 if StT > KI
S,K,KI
ST
K
KI
time
T
A down and in call, not being knocked in, so the payoff of a standard
Condition: S0 > KI
(Book p.315)
d) Down and Out Call (Cdi)
Payoff: max [0, ST - K] if StT > KO
0 if St  KO
S,K,KI
Knock out
of option ST
KO
K
Asset
price S
T
A down and out call, being knocked out, so the payoff of a standard
Condition S0 > KO
(Book p.315)
Why barrier option?

•Cheap!!
•Can reflect precisely investors view
Hedging barriers
(Book p. 315, 312-326)

Price of the up
and out call Cuo
b
c
Asset
16 S* 20 KO = 22 price S
Figure 11.12: The price function of an up and out call. The implied volatility for
function a = 10%, b = 20%, c = 30%.
Differentiating the price functions in figure (11.12), gives the delta of an up and ou
call:
Delta of the up
and out call Cuo
b
c Asset
KO = 22 price S
Delta of a down
and in call Cdi
b
a
Asset
KI price S
a
b
c
Figure 11.14: Delta of a down and in call; a, b, and c as in figure 11.12.

Theta of the up
and out call Cuo
b
c Asset
KO price S
a
Figure 11.15: Theta of an up and out call; a, b and c as in figure 11.12

Vega of the up
and out call Cuo
Asset
c price S
KO
b
Figure 11.16: The vega of an up and out call; a, b and c, as in figure 11.12
Variations of barriers:
•Ratchet option (gains are locked in; if ratchet is infinity,

ratchet option = lookback option)
•Ladder option (cliquet option, reset option): strike is
a function of S
•Shout option
•Partial barriers
•Outside barriers
•Forced exercise
(Book p. 325, 326

Lookback options
Lookback options allow the buyer to buy an asset at the
lowest level or sell it at the highest level that the asset
reaches during the option period.
There are two basic types of lookbacks

•Lookback strike option
•Lookback price option
Remember: The lookback strike option has

no fixed strike!
(Book p. 326, 327

Lookback strike options
In a lookback strike option, no constant strike is set at the
trade date. The strike is the lowest level (min St) for a call or
the highest level (max St) for a put that the underlying reaches
during the option period:
Payoff
Smax
ST
Smin
Asset
T price S
Payoff of a lookback strike put Smax - ST,

payoff of a lookback strike call ST - Smin
Note that the payoff is always  0
(Book p. 326, 327
Lookback price options
In a lookback price option, a strike K is defined at the trade
date, as in a standard option. The payoff of a lookback price
call is max[Smax - K, 0], the payoff of a lookback price put
is max[K - Smin, 0]
Payoff
Smax
Smin
Asset
T price S
Payoff of a lookback price call Smax - K,

payoff of a lookback price put K - Smin
(Book p. 327, 328)
Final thoughts on Lookback options
A variation of a lookback is the Range option, which has

a payoff of Smax -Smin
When to buy lookback options?
Lookback options are popular but expensive!
Hedging lookbacks is often done with plain vanilla

options
(Book p. 327- 329)

Average options
Average options (also called Asian options) give the option

buyer the right to pay or receive the average price of an
asset.
As with lookback options, two types of average options exist
•Average strike option

•Average price option
(Book p. 331)
Average options cont.
In an average strike option, no constant strike is set at the trade

date. The strike is the average Save that the underlying reaches
during the option period.
The payoff of an average strike call is:
max (ST - Save, 0)
An average strike put has a payoff of

max (Save - ST, 0)
(Book p. 331)
Dow Average of Dow
9500
9000
8500
8000
7500
7000
6500
97/12/26 98/01/27 98/02/25 98/03/25
The Dow and the average of the Dow from December 26,
1997 to March 25, 1998. On March 25, 1998 the average
strike call is in the money (ST – Save > 0); the average
strike put is out of the money (Savg – ST < 0).
In an average price option, a strike K is defined at the trade
date, as in a standard option. At option maturity that strike and
the average of the underlying price are compared:
The payoff of an average price call is:

max (Save - K, 0)
The payoff of an average price put is

max (K - Save, 0)
(Book p. 331,332)
Dow
Average of Dow
Strike
9500
9000
8500
8000
7500
7000
6500
97/12/26 98/01/27 98/02/25 98/03/25
The Dow and the average of the Dow from December 26, 1997
to March 25, 1998. On March 25, 1998, the average price put
with a strike of 8,500 is in the money (K – Savg > 0); the
average price call is out of the money (Savg – K < 0).
Why average options?

•Usually cheaper!
•Often better protection!
Pricing average options:
There are several types of averages. The arithmetic,

geometric and harmonic. In practice, usually the
arithmetic price and strike option is traded.
(Book p. 332,333)
Pricing average options cont.
The arithmetic average is
1 n

n i 1
xi
The geometric average is
n
( Si )1 / n
i 1
(Book p. 332)
Pricing average options cont.
No closed form solution has been found so far to price

average options. They are usually priced on trees, see
book p.333-336.
For geometric options, as an approximation, if the implied

volatility is set to vol^-(1/3) and the growth rate is set to
0.5*(r+q+(vol^2)/6), the standard Black-Scholes model
can be applied.
This approach can be extended for arithmetic price
options. See Hull p.466,467 (used in my TRADE SMART)
(Book p. 332 - 336)

To sum up average options
Hedging average options is quite easy, due to the fact,
that the payoff, and therefor the value of the
risk-parameters are accumulating over time.
Although average options are usually cheaper

and often offer customized protection, they are
not overly popular.
However, when easier valuation methods are

available and investors are better informed
about the benefits of average options, they
should become more popular.
(Book p. 332 - 336)

Compound options
A compound option is an option, where the underlying

instrument itself is an option.
There are four types of compound options
A trader can buy or sell a :
•Call on a call
•Call on a put
•Put on a call
•Put on a put
Why compound options??
(Book p. 336 - 337)

Compound options cont.
Crucial dates of a compound option:
Trade date Exercise date of Exercise date of
of compound 1. (compound) 2. (underlying)
option option option
t0 T1 T2
At t0, the compound option premium is paid.

If at T1, the strike K1 = premium of the 2. Option
is lower than PV of the 2. Option, the compound
option is exercised.
The option buyer now has a standard option.
(Book p. 336 - 337)
The payoff of a call on a call is at time T1
max {0, {max [e-rT2 (ST2 - K2), 0] - K1}}

To price a compound option, the bi-variate cumulative
normal distribution is necessary.
Also, we have to determine S* at T1, which is the break even

spot price at T1 to equal K1 and max [e-rT2 (ST2 - K2), 0],
see Kolb p. 260.
We can use Newton-Raphson to determine S*.
(Book p. 338,339)
A Chooser option can be considered a variation of a

compound option.
A chooser option is an option, where the option buyer at
some point in time can determine, if the option is a call or
a put.
When to buy a chooser option??
(Book p. 340 - 342)

Multi asset or correlation options
Multi-asset options are options whose payoff depends on a

given arithmetic combination of two or more assets
Types of multi asset options:
Payoff at option maturity
Option on the better of two max (S1, S2)
Option on the worse of two min (S1, S2)
Call on the maximum of two max [0, (S1, S2) - K]
Exchange option max (0, S2 - S1)
Spread option max [0, (S2 - S1) - K]
Guaranteed return on investment (Grois) max (S1 - K, Premium)
Option on better of two or cash max (S1, S2, Cash)
n
Dual strike option max (0, S1 - K1,nSi S2i - K
K 2)
i 1
•Portfolio or basket option max ( , 0)
(Book p. 342 - 343) ni : number of shares or weight of asset Si
Multi asset or correlation options cont.
A Quanto option is an option, which allows a domestic

investor to exchange his payoff in a foreign currency
back into his home currency at a fixed exchange rate
A quanto option therefore protects an investor against currency risk:

E.g. an American believes the Nikkei will increase, but she is
worried about a decreasing yen.
The investor can buy a quanto call on the Nikkei, with the
yen payoff being converted into dollars at a fixed (usually the
spot) exchange rate
The term quanto comes from quantity, meaning that the

amount that is re-exchanged to the home currency is
unknown, because it depends on the payoff of the option
(Book p. 345 - 346)
The financial institution that sells a quanto call, does not know
two things:
a) How deep will the call be in the money, thus which yen
amount has to be converted into dollars
b) What is the exchange rate ($/1yen) at option maturity at

which the stochastic yen payoff will be converted into dollar
The correlation between a) and b), the price of the underlying

S’ and the exchange rate X, significantly influences the quanto
option price.
The more positive the correlation coefficient, the lower the

price for the quanto option! Why??
(Book p. 345 - 346)
A positive correlation means:

•If S (Nikkei) increases, the $/1yen increases
Thus, if the call finishes in the money (high S),
the call seller has to use less yen to convert into
$ to make the make payoff.
Thus a high correlation has a “compensation effect”
thus a high correlation means a lower quanto call price
•If S (Nikkei) decreases, the $/1yen decreases
Thus, if S decreases and the call will not finish deep in the money,
the quanto call seller has to use more yen.
Again, we have a “compensation effect”
(Book p. 345 - 346)
Pricing Quantos
The payoff of a quanto call option isX
X” max [S’ - K’, 0]

X” : exchange rate defined as domestic currency per one unit
foreign currency, (so $ / 1yen) at which the conversion of the
foreign payoff into the domestic currency will take place
S’, K’: spot price and strike price in foreign currency (yen)
To price a quanto call in domestic currency we can take the
standard Black-Scholes equation (9.1), multiply by the
exchange rate X”, replace S with S’X, K with K’X and the
dividend yield q by (r + d - r’) + ( S’ X).
(X: current exchange rate)
(Book p. 346 - 347)
Doing so, we get
_
X”[S’e-q T N(x1)- K’ e-rT N(x2)]

where

S' e q T 1 2
ln( )       S' T
and x2 = x1 -  S' T
 r 'T S 'X S' X
K' e 2
X1 =
 S' T
where
_
q = r + d - r’ + (S’X S’ X)

S’X
: correlation coefficient of the spot price in foreign
currency and the exchange rate
(Book p. 346 - 347)

Combinations of exotic options
Delayed rate setting (DRS): Bond issuer can choose within

a certain time period when to lock in a certain spread
over treasury. A DRS equals an American style, forced
exercise option.
Fixed maturity Bermuda style swaption: In a fixed
maturity Bermuda style swaption, the buyer has the right to
enter into a swap, whereby the option period plus the swap
period are a constant
Convertibles: A convertible in its simplest form is a bond,
which can be converted into a defined number of stocks.
Thus, the investor has an exchange option!, who’s strike
increases, because a convertible bond is usually issued at
par. Convertibles are often also callable, thus fairly
complicated
(Book p. 348 - 349)
Convertibles
A convertible is a bond, which can be converted into a fixed
number of stocks by the bonds buyer, at predefined points
in time.
Thus, a convertible has the feature off an exchange option
max (0, S2 - S1)

Usually convertibles are callable, which means that the issuer
has the right (option) to buy back to the convertible
at a predefined price.
Thus, the bond buyer AND the issuer both have an option!!!
(Book p.161)
Convertibles, non-callable
Non-callable convertibles can be priced as an exchange option.
Another approach is to divide the convertible price
into the bond price and the conversion option value:
Convertible Price = Bond price + Conversion Option value
The conversion value (not conversion option value) is simply

the number of stocks to be received times the stock price.
Conversion is sensible if
Convertibles, American style callable
Usually convertibles are callable, which means that the issuer
has the right (option) to buy back to the convertible
at a predefined price, the call price, Q2.
Usually convertibles are American-style, therefore we have

to value them using a binomial or trinomial model.
Ask each node, we have to test, if it is a rational for the

convertible holder to convert AND if it is irrational for
the issuer to call.
Let’s define:
Q1 : Value of the convertible bond, derived by rolling back
through the tree, assuming the convertible bond is not
converted nor called.
Q2 : Predefined Call price, at which the issuer can buy

back the convertible bond
Q3 : Conversion value = number of stocks to be received

per 1 bond conversion times the stock price
Testing whether the convertible bond should be converted AND

Called, can be expressed as
(Hull p.529)
Q1: Convertible price
max [min (Q1, Q2 ), Q3] Q2: Issuers call price
Q3: Conversion value N*S
Explanation:
min (Q1, Q2 ) represents the issuers calling option:
If Q1 < Q2 →
If Q1 > Q2 →
max [min (Q1, Q2 ), Q3] represents
If min (Q1, Q2 ) < Q3 →

If min (Q1, Q2 ) > Q3 →
Conclusion: In order to price American-style callable convertibles
we have to build a tree and put
at each node the tree
What does max [min (Q1, Q2 ), Q3] exactly imply?? Q1: Convertible price
Q2: Issuers call price
Q3: Conversion value N*S
An example:
Q1 = 103, Q2 = 80, Q3 = 95
First, the bond holder checks:
Second, the issuer checks:
Third, bond holder checks again:
Hence, max [min (Q1, Q2 ), Q3] implies that the bond holder has
Is this realistic???
One issue is the right choice of the discount factor.

Stocks grow with the risk-free interest rate, whereas
a bond grows with the yield.
Therefore, we have to discount back with the yield

of the bond, if the bond has not been converted, and
the discount back with the risk-free interest rate, if
the bond has been converted.
Swaps
A swap is an agreement between two parties to exchange a series of
cash flows.
Total US Derivative Activity
$80,000.00
$70,000.00
$60,000.00
$50,000.00 Futures & Fwrds

Swaps
$ Billions
$40,000.00 Options
Credit Derivatives
$30,000.00 TOTAL
$20,000.00
$10,000.00
$-
91Q4 92Q4 93Q4 94Q4 95Q4 96Q4 97Q4 98Q4 99Q4 00Q4 01Q4 02Q4 03Q1 03Q2 03Q3
(Book p.233)
Swaps - An overview
Swaps
In te re s t ra te C u rre n c y C o m m o d ity E q u ity C re d i t S w a p s V o l a ti l i t y S w a p s /

sw aps sw aps sw aps sw aps V a ri a n c e S w a p s
F lo a ti n g - F lo a ti n g - H y b ri d s : F lo a ti n g - F lo a ti n g -F i x e d F i x e d -F i x e d F lo a ti n g -F lo a ti n g F lo a ti n g -F i x e d F lo a ti n g -F lo a ti n g F lo a ti n g -F i x e d
F lo a ti n g F ix e d -D i f fe re n ti a l s w a p F lo a ti n g (C ro s s c u rre n c y (C u rre n c y s w a p -y i e ld c u rv e s w a p s (P la i n v a n i l la ) -T R O R s w a p s -D e fa u lt s w a p s
- Y i e ld c u rv e s w a p - P la i n v a n i l la -L i b o r i n a rre a rs (B a s i s s w a p ) sw ap) (c o n ta n g o , b a c k w a r-
- E o n ia -In d e x p ri n c i p a l s w a p d a ti o n s w a p s )
Most actively traded swaps in the different markets
(Book p.118)
Interest rate swaps
An interest rate swap is an agreement between two parties to
exchange a series of cash flows based on different interest rate
indices, on the same principal amount, for a given period.
The most common type of swap is the plain vanilla fixed-floating

interest rate swap:
In a fixed-floating interest rate swap, one party pays a fixed interest rate.
This fixed rate, i.e. 7%, is paid on the principal amount, annually or sub-
annually, during the life of the swap.
The other party pays a floating interest rate. This floating rate is more
interesting. It depends on the future process of interest rates and is
therefore stochastic (unknown).
(Book p.117)
Interest rate swaps cont.
7%
A B
6ML
For a 2-year swap, annual on fixed side , semiannual on the floating side the
cash flows are:
t0 t0.5 t1 t1.5 t2
(Book p.119)
Example of an interest rate swap
Let’s assume, we have a 2-year swap against 6ML, 7% annually on the fixed
side, semiannually on the floating side, and $1,000,000 principal amount.
Let’s assume the fixings of the 6ML are 6% at t0, 6,5% at t0.5, 4% at t1 and 6% at t1.5.
Let’s also assume, t0.5 - t0 and t2 - t1.5 are 182 days and t1 - t0.5 and t1.5 - t1 are 183 days.
Thus, the fixed rate payer pays,

The floating rate is usually paid “in arrears”.This means it is paid at the following
fixing date.
Thus, the floating rate payer pays,
(Book p.119,120)
Example of an interest rate swap cont.
Thus, the cash flows are as follows:
$33,041.67
$30,333.33 $20,333.33 $30,333.33
t0 t0.5 t1 t1.5 t2
$70,000 $70,000
Result:
(Book p.119,120)
Why interest rate swaps ?
There are 5 main reasons for the success of interest rate derivatives:
 Speculation
 Hedging
 Cost reduction
 Arbitrage
 Off balance sheet feature
(Book p. 120)
Reducing cost with an interest rate swap
Read p. 6 to 8 Thank you
OK here’s the example:

Company AAA and company BBB both want to invest $50 mio in the USA and 50 mio
pound in GB. For simplicity purpose, the exchange rate is 1.
Company AAA can borrow money in the USA and GB cheaper than BBB:
US $ Pound Sterling
Company AAA 7% 8%
Company BBB 9% 9.5%
As seen, BBB has a relative advantage over AAA in GB, where is only pays 1.5% more
interest than AAA, compared with paying 2% more when borrowing in $.
(Book p. 6)
Reducing cost with an interest rate swaps cont.
From the table it follows: If AAA would borrow $50 million in the USA and 50 million
pound in GB it would pay:
50 mio * 7% + 50 mio * 8% = 7,500,000 in interest.
If BBB does the same, it would pay:

50 mio * 9% + 50 mio * 9.5% = 9,250,000 in interest.
If AAA however uses its comparative advantage and only borrows in the USA, AAA would
pay:
100 mio * 7% = 7,000,000.
If BBB uses its comparative advantage and only borrows in GB, it would pay:
100 mio * 9.5% = 9,500,000
Since both companies want to invest 50 million in each country, they can now enter into a
fixed-fixed currency swap:
(Book p. 6,7)
If AAA gives 50 million $ to BBB for 8%, and BBB gives 50 million pound to AAA at
8.75%, it follows:
50 mio $
50 mio * 8%
AAA BBB
50 mio * 8.75%
100 mio 100 mio
$ 50 mio pound pound
100 mio $
100 mio pound
* 7%
* 9.5%
Creditor in Creditor in
USA GB
Fig: Companies AAA and BBB each using their comparative borrowing advantage and
entering into a fixed-fixed currency swap
(Book p. 6,7)
In the swap, AAA pays $50 mio * 8.75% = 4,375,000, BBB pays 50 mio pound * 8% =
4,000,000. Netted, AAA pays 375,000 to BBB in the swap (the exchange rate is assumed to
be 1)
The overall borrowing costs for AAA are therefore 7,000,000 (from borrowing in
$) + 375,000 from the swap = 7,375,000
The overall borrowing cost for BBB is 9,500,000 (from borrowing in pound) -
375,000 from the swap = 9,125,000
Bottom line therefore is:

Using their comparative borrowing advantages and entering into a
swap, both companies AAA and BBB reduce their financing costs by
$125,000
The interest rates paid in the swap, 8.75% and 8%, were chosen so that both companies
reduce their financing costs by 125,000. In reality the exact levels are determined by
negotiation.
(Book p. 8)
Hedging interest rate risk with an interest rate swap
Example:
Company A has a floating rate loan on $1 million. The company is
afraid that interest rates will rise and wants to eliminate this interest
The company therefore enters rateinto risk.
a swap, where it pays a fixed rate
(7%) and receives a floating rate (6ML)
7%
Company Swap
A counterpart
6ML
1 mio $ 6ML
Loan
provider
Result:
(Book p. 121)
Overnight Interest Rate Swap, e.g. Eonia
An overnight swap is simply a short dated interest rate swap.
The floating interest rate is the overnight rate. The fixed

interest rate varies of three months to two years.
Overnight interest rate swaps are not so popular in the

United States, but popular in Europe.
The Eonia swap is a type of overnight interest rate swap

on the Euro, in which the overnight rate is volume-weighted.
The volume refers to the volume of overnight loans.
Why overnight interest rate swaps???
Overnight interest rate swaps are mainly used to protect
against overnight interest rate exposure:
7%
Company Swap
A counterpart
Accumulating
ON Rate,
volume weighted
Accumulating
1 mio $ ON Rate,
volume weighted
Loan
provider
Result:
How can Eonia swaps be priced?
Just like interest rate swaps.
Do we have to include the volume weighting?

Yes, if there is a correlation between the direction of
interest rates and trading volume.
There should be a negative correlation between the
overnight rate and overnight loan volume,
because the higher the overnight interest rates,
the less borrowing will take place.
This benefits the swap counterpart
Therefore the Eonia Fixed rate should be higher than
a standard, non-volume weighted Eonia
The cross-currency swap
An US company “A” wants to invest in Germany, therefore needs Deutsch
Mark (DM).
Since the company is better known in America, it can borrow money

cheaper in the US.
Furthermore the company wants to pay a floating rate on its loan. The
loan amounts to 1.5 million DM, the spot exchange rate is 1.50 DM/$.
In this case the following cross-currency swap is advantageous for

company A :
(Book p. 122)
The cross-currency swap cont.
At the beginning of the swap the principal amounts are exchanged
$ 1 mio
$
Swap
Company
A counterpart
DM 1.5 mio
$ 1 mio
Loan
provider
in the US
(Book p. 122)
During the investment period = during the swap period, the interest rates
are exchanged
6 ML in DM
Company Swap
A counterpart
5% in $
5% in $
Loan
provider
in the US
(Book p. 122)
At the maturity date of the swap, the principal amount is re-exchanged
$ 1 mio
$
Swap
Company
A counterpart
DM 1.5 mio
$ 1 mio
Loan
provider
in the US
Result:
(Book p. 122)
The equity swap
With an equity swap, a floating rate return (or liability) can be swapped
into an equity return (or liability).
E.g., an investor who has originally bought a floating rate bond to
receive Libor, however now believes the IBM stock will increase, can
enter into the following equity swap:
% change of
%change ofIBM
IBM
Investor Swap
Swap
Investor counterpart
counterpart
6ML
6ML
$$11mio 6ML
6ML
mio
Floating rate
Floating rate
bond issuer
bond issuer
Can the Investor be paying in both legs???
(Book p. 122)
The asset swap
In an asset swap, the fixed rate is received from an asset
6ML+200BP
Swap
Asset
counterpart
Holder
6%
Asset
6%
$1 mio
coupon
Mexican
Bond
Since asset swaps are called asset swaps, plain vanilla swaps should be called “Liability Swaps”
Does the hedged asset holder have Mexican Bond Credit Risk???
Does the hedged asset holder have Interest Rate Risk???
Default Swaps are priced in practice following asset swap Prices (see 5 slides forward)
Pricing of Interest Rate Swaps
How to derive a Forward Rate rf
rs rf
t0 Ts Tl
rl
Given are the short term spot rates rs and the long term rate rl
Without compounding, at any (general) time Ts, 1 dollar will be
Example: If rs = 10% and Ts = 1 year, $1 at the end of year 1 is
Given rs and rl, how can we derived rf???
With an arbitrage argument:
Solving for rf, we get:
(Eq 4.2) or, since dfx = 1/(1+rxTx)

How to derive a Forward Rate rf
1  rl Tl 1
rf  (  1) x
1  rs Ts Tl  Ts
Example: If rs = 10%, rl = 11%,Ts = 0.5 years and Tl is 1 year, what is the 6 month
forward rate starting in 6 month?
It is
This 6 month forward rate, as the rate rs is a nominal, semi-annual rate.
Hence, if you pay the forward rate in 6 month for 6months, you pay
More on Forward Rates
To calculate forward rates, it is convenient, to use the concept of continuous compounding (cc)
An interest rate r with compounding m, rm, is converted to a cc rate rcc by
rcc = ln (1+ rm/m) x m
Example: An annual rate (hence m = 1) of 10% is equal to a cc rate of
Applying equation (4.2) for cc rates, we get
e rlTl  e rsTs x e rf Tf
Using ln ex = x and ln (axb) = ln a + ln b, and Tf = Tl-Ts, this reduces to
More on Forward Rates
rfcc  (rlccTl  rsccTs )/(Tl  Ts )
Example: Given are the nominal rates rs = 10%, rl = 11%,Ts = 0.5 years and Tl is 1 year.
What is the 6 month forward rate starting in 6 month?
The cc rates are

and
Therefore,
This is the same as

Pricing and Risk of Interest Rate Swaps
The floating leg of the swap has very little influence on the present value of the swap!!!
Why???
Because the floating leg pays
That is why a floating rate bond at the reset date has a value of
(A floating rate bond can also be viewed as a short term fixed rate bond)
If the floating bond would be reset continuously, the value would be always
Floating rates in a swap are reset every 3 months or 6 months. Hence the
interest rate risk is
Hence, to calculate the VAR of a swap, we can concentrate on the

What determines the present value (= price) of an interest rate swap???
Why???
Because if you receive a higher fixed rate in the swap than the market rate,
or pay a lower fixed rate in the swap than the market rate
this is considered and vice versa
(See VAR of Interest Rate Swaps in TRADE SMART)

Although the crucial interest rates to determine the present value of a swap are
the fixed rate and the current market equivalent fixed rate, the present value of a
swap (PV), from the viewpoint of the fixed payer, is derived by
PV (floating side) – PV (fixed side) more precisely, for swap settlement
n m
 NPA
i 1
i li r f (i - 1, i) df(s, p i ) - R  NPA j l j df(s, p j )
j1
(5.19)
where i: floating side reference dates, j : fixed side reference dates, NPA : notional principle amount,
l : time period between reference dates i-1 and i, r f : forward rate, df : discount factor, s : valuation date (e.g.
today), p : payment date, R : fixed swap rate
The floating side:

df(s,1)
rf(0.5,1) (Column CW in Swaption
model, sheet 1)
s p0.5 p1
df(s, i - 1) 1
[Using rf (i - 1, i)  (  1) , the term r f(i-1,i) df(s,i) li in (5.19) = ( df(s, i - 1)  1) 1 df(s, i) (i - 1, i) = ]
df(s, i) (i - 1, i) df(s, i) (i - 1, i)
(see 6 slides earlier)
To derive the fix, fair mid-market swap rate R*, we set equation (5.19) to 0 and solve for R:
(5.19a)
A swap trader will construct his bid-offer spread around R*.

Pricing Options: An Overview
The difference between pricing stock options and swaptions and default swap options
is:
Stock option (Call)
S
t Tm
Call price C
Option period K
Swaption (Payers)
Tm : Option maturity
t Tm= T0 TN T0: Swap start
Floating leg is stochastic

Option period Swap period
Option on CDS (Call)

Payoff in case
of default Occurrence and timing
t Tm= T0 TN of all CDS cash flows is
s* s* s* stochastic, i.e.
Call
τ
price
Option period CDS period

Option on CDS vs Credit Spread Option
Payoff in case
ai of default
t Tm= T0 TN
Call s* s* s*
τ
price
Hence the payoff of a CDS option at Tm is max( [s(Tm )  s*],0) Vfee ε = +1 for a call and -1 for a put
B/B
The payoff of a credit-spread option is typically max( [s(Tm )  s*],0) NPA
y
Difference Option on CDS – Credit spread option
• Option on CDS is ‘default and out’ i.e. knocked out if default occurs from t to T 0.
• Underlying of Credit spread option should be floating bond to eliminate interest rate effects;
reference of CDS is typically an entity (company, sovereign)
Pricing Options: Critical Issues
The most critical issue when valuing options is modeling the stochastic process of the
underlying variable, i.e.
a) the growth rate from t to option maturity Tm and

b) the distribution at option maturity Tm.
The distribution has to modeled at swap start T0 , if Tm < T0.
Stock option
a) Since risk-neutrality applies, the growth rate of the stock S from t to Tm (as for every
variable) is the risk-free rate r. Merton (1973) included dividends q, which are equivalent to
Garmen Kohlhagen’s (1983) foreign interest rate for currency options or the convenient
yield for commodities (Black 1976.) Hence the growth rate of S is r-q and
E(S(Tm )) 
Example: Microsoft has a current stock price S(t) = $100. The risk-free interest rate r = 5%,
the dividend yield of Msft is 2%. What is the expected Msft stock price in half a year?
Stock option continued
b) In Black-Scholes it is assumed that the underlying variable is lognormally distributed at Tm
Average growth
rate r-q
Tm
Mathematically, the relative change of S, dS/S follows a generalized Wiener Process
dS/S = (r-q) dt + σ ε dt
where ε ~ N(0,1), i.e. a random drawing from a
(since the logarithm of the logarithmically distributed S is normally distributed)
If the relative change of a variable follows a generalized Wiener process, this is typically referred to as a
geometric Brownian motion.
dS/S = μ dt + σ ε dt
The discrete version is
S/S = μ t + σ ε t
Example:
The present stock price is $100, next year's expected return is 15%, the annual expected
volatility is 30%. The sample drawing from a standardized normal distribution results in
+0.5.
What is the expected stock price in one day (=1/365) due to the geometric Brownian motion?
(See www.dersoft.com/geometric.xls)
Pricing Swaptions
t Tm
Payers price p1 p2=TN
To determine the fair forward swap rate Rf (for swap and cash settlement), for time Tm, seen at
t, we discount all stochastic floating cash flows NPAi and the non-stochastic fix rates NPAj of
the swap period to t (see Swaption model, sheet 3 cell CX109)
 NPA i li R f (i - 1, i) df(t, p i ) PV (Floating Side)

(10.6a) R f (t)  i 1
m
 NPA
j1
j l j df(t, p j ) PV (Fixed Side)
l: time period between i and i-1, df(t,p) : discount factor between time p to t, p ≥ t
This equation is mathematically identical with the one for determining the fair swap rate in a swap
(5.19a). The only difference is that the cash flow payment dates are now further in the future, in the
optional swap period.
Remark: Rf(t) is a martingale, hence E(Rf(Tm) =

as today's Future price F(t) which is assumed to be the Future price at Future maturity F(T m)
Pricing Swaptions
To evaluate the Swaption (swap settlement) , we can now use a simple Black 76 (for Options
on Futures) approach
n
 NPA
j1
l
j j df(t, p j ) κ [(R f (t) N(d1 )  R *
N(d 2 )] eq. (10.11)
κ = +1 for a payer, κ = -1 for a receiver
ln(R f (t)/R * )  0.5σ 2 Tm ln(R f (t)/R * )  0.5σ 2 Tm

d1  κ d2  κ
σ Tm σ Tm
This approach assumes a of R f and constant

lognormal distribution
volatility.
If a variable (Rf) is lognormally distributed, the relative change (dRf/Rf) for a short
time period is normally distributed . Including the martingale property of a zero
growth rate, we see that Rf is modeled:
dR f _
 σ ε dt eq. (23)
Rf
For comparison, the original Black 76 approach is
NPA df(t, Tm ) κ [F(t) N(d1 )  K N(d 2 )]

Pricing Swaptions, Swap settlement vs. Cash settlement
t Tm
Payers Swaption
Payers price p1 p2=TN
Swap settlement means the buyer will enter into the swap at time Tm, if at time Tm, R*<R(Tm)
m
Cash settlement means the buyer will receive [R(Tm) - R*]  NPA
j1
j lj
For swap settlement, the pricing equation is
 NPA
j1
l
j j df Rj (t, p j ) κ [(R f (t) N(d1 )  R *
N(d 2 )] (10.11)
For cash settlement, the pricing equation is
n
df R f (t, Tm ) NPA j l j df R f (Tm , p j ) κ [(R f (t) N(d1 )  R * N(d 2 )] (10.8)
j1
Pricing Swaptions, Swap settlement vs. Cash settlement cont.
Due to the difference in discounting, swap settled and cash settled swaption prices can differ
Can we exploit that???
1)
2)
In practice, if the yield curve is upward sloping, typically PV (cash settled) < PV (swap
settled)
Options on CDS – Generating the fair forward CDS rate sf
Payoff in case Occurrence and timing

of default of all CDS cash flows is
t Tm TN stochastic, i.e. default
Call s* s* s* probability dependent!
τ
price
Can we use the interest rate Swaption approach of equation (10.6a) of simply discounting
the cash flows in the CDS period to t to derive the fair forward default swap rate s f???
We need a model to derive sf as a structural or reduced form model,

or as an approximation the asset swap spread or the yield spread.
Options on CDS – Generating the fair forward CDS rate s f
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
In the reduced form environment, the Payoff leg with a payoff of (1 - RR - aiBRR) can be modeled as
1-RR-aiBRR
λ0
1-RR-aiBRR
λ1
0 1-RR-aiBRR
1 λ 0 λ2
1 λ1 0
1 λ 2 0
time t=0 t=1 t=2 t=3
Mathematically:
λ 0 (1  RR  ai B RR)  (1 - λ 0 )λ1 (1  RR  ai B RR)  (1 - λ 0 )(1 - λ1 )λ 2 (1  RR  ai B RR) or
N t -2
λ 0 (1  RR  ai B RR)   λ t -1 (1  RR  ai B RR) (1 - λ u ) (10.6b)
t 2 u 0
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
In the reduced form environment, the Payoff leg with a payoff of (1 - RR - aiBRR) can be modeled as
1-RR-aiBRR
λ0
1-RR-aiBRR
λ1
0 1-RR-aiBRR
1 λ 0 λ2
1 λ1 0
1 λ 2 0
time t=0 t=1 t=2 t=3
Mathematically:
λ 0 (1  RR  ai B RR)  (1 - λ 0 )λ1 (1  RR  ai B RR)  (1 - λ 0 )(1 - λ1 )λ 2 (1  RR  ai B RR) or
N t -2
λ 0 (1  RR  ai B RR)   λ t -1 (1  RR  ai B RR) (1 - λ u ) (10.6b)
t 2 u 0
Options on CDS – Generating the fair forward CDS rate sf
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
Simplifying equations (10.6b) and (10.6c) by
• Redefining the conditional (risk-neutral) forward probs λt as spot probs
• Assuming identical fixed rates s*, hence s1*  s*2  s*2 ...  s *
• Including possibility of any default time i or j and hence including accrued interest
ai
• Including a notional principal amount NPA
The payoff leg (eq. 10.6b) then becomes

TN
NPA
TN
NPA l l [1[1--RR
RR--aiai RR]
i
i RR] λλ df(t,
i
i df(t,pp)) B
B
i
i
i
i
(default elements, upward arrows)
i 1
i 1
The premium payment leg (eq. 10.6c) then becomes

TN TN
ss**[(NPA df(t,pp) )

TN TN
[(NPA aiaiNPA
j NPA ) )l l λλ df(t,
j NPA
j NPA (1(1- -λλ) )df(t,
j
j
j
j df(t,pp)])]
j
j
j
j
j
j
j
j
j
j1 j1
j1 j1
Default elements No default elements

(upward arrows) (downward arrows)
where
i: floating side reference dates
j : fixed side reference dates
NPA : notional principle amount
l : time period between reference dates i-1 and i or j-1 and j
RR : recovery rate of the reference asset
ai : accrued interest of the CDS rate s* from the last payment date to default date
aiB : accrued interest of the reference asset from the last coupon date until default
The payoff is (1 – RR – aiBRR)
λi : risk-neutral spot default prob at time i (includes conditionality)
s* : rate paid in the CDS by the CDS buyer
df : discount factor,
t : valuation date (e.g. today)
p : payment date
TN : maturity date of the forward CDS
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
The value of the CDS from the viewpoint of the CDS buyer is
PV (payoff) – PV (fee payments) hence:
TN TN TN
 NPA i li [1 - RR - ai B RR] λ i df(t, pi ) _

 s *[(NPA
j1
j  ai NPA j ) l j λ j df(t, p j )   NPA j (1 - λ j ) df(t, p j )]
j1
i 1
Setting this to 0 and solving for s*, we derive the fair (forward) swap rate of the forward CDS,
seen at time t, sf (t):
T
TN N
(t) TN
NPA
NPA l l [1[1--RR
i 1
i
RR--aiai RR]
i
i
iRR]λλ df(t,
df(t,pp))
B
B
i
i
i
i
ssf f(t) i 1
T
TN N
(NPA df(t,pp)) NPA

TN
(NPA aiaiNPA
j1
j1
j
NPA ))l l λλ df(t,
j
j
j
 NPA l l (1(1--λλ))df(t,
j
j
j
j df(t,pp))
j
j
j1
j1
j
j
j
j
j
j
j
j
(10.6c)
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
Once we have derived the fair forward CDS rate s f (t), we can use the martingale property to derive
the expected value of the CDS rate s f at time Tm:
EQVfee(sf(Tm)) = (eq. 22)
Summary
Summaryofofthe
thederivation
derivationofofssf:f:
• Discount all default probability weighted cash flows of the 2 legs in the forward CDS period to t
• The fair rate sf(t) is then derived as the rate at which the PV of the legs are the Fee leg (t)
s f (t) 
same Payoff leg (t)
• Use the martingale property to derive E Q (sf(Tm)) = sf(t)

Options on CDS – The Black 76 analogy
Once we have derived the fair forward CDS rate s f, we can relax…
We can use the Black 76 interest rate swaption approach and rewrite equation (10.11)
NPA
n
N(d ))ss**N(d
 NPA l l df(t,
j1
j1
df(t,pp ))κκ[(s
j
j
j
[(s (T
j (T))N(d
j
j
f
f N(d )])]
0
0
1
1
2
2
(10.11a)
f (t)/R)0.5σ
ln(R (t)/R)
ln(R
2
0.5σ2 T Tm ln(R (t)/R)  0.5σ 2
2 T
ln(R f (t)/R)  0.5σ Tmm
 dd2 2κκ
f
d
d1 1 κκ f m
σ
σ TmmT σσ TTmm
where j : fixed side reference dates, NPA j : notional principle amount of fee payment at time j, l : time
period between reference dates j-1 and j, df : discount factor, sf : forward rate, s* : strike rate, t: valuation
date (e.g. today), p : payment date, κ : 1 for a call, -1 for a put
What about the default probabilities???

What about default of the reference asset during time t to Tm???
Since the fee leg and the protection leg are 0 from time t t0 Tm, s f in (10.6c) is undefined!!
Options on CDS – The survival measure technique
is as convenient as the proof is complex... (Schönbucher WP 2000, RISK

2004)
Main Properties
• After having derived sf on the basis of default probabilities, we now model the option
process not with default probabilities, but survival probabilities
• Using only survival probabilities, we are in a world conditional of no default. Especially

default of the reference entity from t to option maturity T m has a 0 probability!
• Hence we do not have to concern ourselves with the problem of default of the reference
asset from t to Tm. Hence we can use the standard Black 76 approach (10.11a)!!!
Some math…
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
If a rate process sf (Tm) has the properties:
Q
(Tm))))ss f(t)
EEQ (s(sf f(T (t) for all t ≤ Tm
m f
Or discounted with factors b(Tm) and b(t)
 s (T ) ) ss (t)
Q s f(T m f (t)
E  fb(Tm ) fb(t)
EQ
b(Tmm)  b(t)
then sf(Tm)/b(Tm) is a spot Q-martingale (which is equivalent to a certain probability measure P,

r
which relates to choosing a certain market price of risk, or Sharpe ratio 
) 
It can be shown that when the market assumes a price process is a martingale, then there is
no arbitrage (Proof Harrison Pliska 1981, Amman 2001)
Closely related, Martingale probabilities or risk-neutral probabilities guarantee the absence of

arbitrage (Jarrow Lando Turnbull 1997)
(www.dersoft.com/jlt.xls)
Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
Let A(Tm) > 0 be a dividend_ free asset and Q a spot martingale. 0 ≤ t ≤ Tm.
It follows that the payout A (T ) with   T (later used a numeraire) hence in survival, is
Q  b(Tm ) 
_
Q  b(Tm ) 1
_
A TN (Tm )  E A ( T ) F
A TN (Tm )  E  b(T )1{Tm m) A(TN ) FTm m
 {   T ) N T
b(TNN) 
where b(Tm) is a numeraire, b(TN) is a discount factor, FTm is a probability space, 1 is default indicator
Using the Radon-Nikodym density process, we define
d(QAA) )
d(Q A(Tm ) b(0)
 A (T ) :A (Tm ) b(0)
A
L
d(Q) T  L (Tm ) : bb(T
m
d(Q) (Tm) )AA(0(0) )
T m m
m
we derive the properties that

Payoff in case
of default
t Tm= T0 TN
τ
Call s* s* s*
ai
price
The survival probability

_ QA is the ratio between the defaultable asset A and the default free
version of A, A
A(0)
A [   T ] A (0)
A
Q
Q [  Tmm]  _ _ _
E.g. A(0) = 90 and A = 100, → QA = 90%
AA(0(0) )
_
A
The Q T - default probability is 0
_
_A
QQ [[TTmm] ]00
T
AT
_
For our sf(t) cash price process, the AT survival price is
ssf f(T
(Tm) )
_
_A
sAT
f (
T
Tm ) 
s f (Tm )  _ _ m 11{T{mTm }}
AATT(T (Tm) )
m
_
where is a martingale.
_
AT
sf Q AT
_ _
well defined for Tm   . But as long as we work under Q A T , we can change the process
AT
As seen, s f
and redefine it to be 0 when !!!
Option on CDS - Modeling the forward rate sf
1) CEV (Constant Elasticity of Variance) family:
The approach (10.11a) assumes a lognormal distribution of s f at time T0.

If a variable (sf) is lognormally distributed, the relative change (dsf/sf) for a short
time periodnormally
is distributed . Including the martingale property of a zero
growth rate, we see that sf is modeled:
_
ds f  s  ε dt
γ
f
Choices to model sf within the CEV family are
a) For γ = 1, we have the lognormal model of sf as (10.11a)
b) For γ = 0, we have the Gaussian model of s f
c) For γ = 1/2, we have the square root model of s f
All choices are used in practice:
a) Yields into the popular Black 76 model, b) is analytically convenient,

c) is popular since it avoids negative forward rates
Option on CDS
Another choice to model sf is via Geometric Brownian Motion (GBM) together with a
2) Jump Diffusion Process
2a) A Poisson Process modeling Jumps
A Poisson Process dq in its most simple form is
 0 with prob 1 - λ dt
dq  
 1 with prob λ dt
where λ is the “intensity”. λ dt is the probability of a jump occurring in the time step dt.
Adding a Poisson process to the GBM, we get
St  Δt  St  St μ Δt  St σ ε Δt  S (J  1)dq
Where J – 1 represents the jump size. (For J=0.1 it follows that S jumps by JS, so to 90% or 110% of the previous S)
see Models
www.dersoft.com/poisson.xls
www.dersoft.com/geometricwithjump.xls
Option on CDS
Properties of the process
St  Δt  St  St μ Δt  St σ ε Δt  S (J  1)dq
are:
Option on CDS
2b) Merton’s 1976 Jump Diffusion Process
A special, elegant case of the Jump Diffusion Process is Merton’s famous 1976 model,
where the logarithm of the size of the percentage jump is normally distributed with stdev s:
ln(J) = Nd~(m,s2). The model is:
'

e  λ T (λ 'T) n

n 1 n!
VBS (S, t; σ n , rn )
where
VBS : Black - Scholes option value

λ '  λ(1  k) k : expected Jumpsize, k  E(J - 1)
λ : Jump intensity, λdt : Jump prob for time period dt
nγ
σ 2n  σ 2  nsT rn  r  λk  and γ  ln(1  k)
2
T
s : Stdev(ln(Jump)) n : number of jumps T : Option maturity
Option on CDS
Another choice to model sf is via
3) Stochastic Volatility
Additionally to the GBM of the underlying S,
dS = μ1 S dt + σ1 S dX1
the volatility σ is also modeled by a stochastic process
dσ = μ2 (S,σ,t) dt + σ2 (S,σ,t) dX2
The Wiener processes dX1 and dX2 are typically correlated with ρ
Option on CDS
3) Stochastic Volatility cont.
Particular stochastic vol models are
Hull-White 1987
d(σ2) = a (σ2L - σ2) dt + c σ2 dX2
Properties are:
• σ2 is mean reverting at rate to the long term mean of σ2, σ2L
• dX1 and dX2 are uncorrelated
• Value of option must be found numerically, but simple approximations

using
Taylor series exist
More on Mean Reversion
Mean reversion is the tendency of a variable to move toward it’s long term mean
Examples of Variables:
• Interest rates • Volatility • Credit Spread
• Currencies? • Stocks? • Commodities?
d(σ2) = a (σ2L - σ2) dt + c σ2 dX2
Example of Vol mean reversion
σ2L = 30%, σ2 = 20%
For a = 1, we have
For a = 0.5, we have
For a = 0, we have
Option on CDS
Another popular stochastic vol models

is
GARCH (Engle 1982, 1993; Bollerslev 1986)
The GARCH (1,1) model is
σ 2t  γ σ 2L  α u 2t 1  β σ 2t -1
ARCH is a special case of GARCH σ 2t  w  α u 2t 1
In GARCH
γ , α, β are weighting factors, typically estimated by regressions, γ  α  β 1
ut = (St-St-1)/St-1 or derived as the error term in a lagged regression St = a + b St-1 + error
see www.dersoft.com/capturing.doc
Option on CDS
Properties of GARCH
σ 2t  γ σ 2L  α u 2t 1  β σ 2t -1
• Principle of ‘Clustering’ (the more recent an observation, the higher the weighting)
Exponential “Decay rate” is β.
• It can be shown that GARCH reduces to the stochastic vol model:
d(σ2) = a (σ2L - σ2) dt + c σ2 dX2
where a = 1 - α – β and c = α sqrt(2)
• Hence GARCH implicitly includes
• GARCH (1,1) by far the most popular

Options on CDS
Exponentially Weighted Moving Average (EWMA)
σ 2t  (1  λ) u 2t -1  λ σ 2t -1
Properties of EWMA
• Similar to GARCH, just that GARCH has an additional weighted

long term vol σ2Lfactor.
• The β in GARCH corresponds to the in EWMA
• Hence, EWMA is a special case of GARCH with γ = 0, α = 1-λ and β = λ

Options on CDS
Another choice to model sf is on the basis of a
4) Rating Transitions
Let K denote the number of initial rating classes (excluding default since we are under
QVfee) and λij the transition probability from state i to state j.
An example for K = 3 is
Rating at
year end
j A B C D D : Default
Initial Rating i
A 0.7 0.15 0.1 0.05
B 0.1 0.6 0.2 0.1

λ i 1
C 0.05 0.15 0.65 0.15
D 0.0 0.0 0.0 1
Transition probs in the last column D are often referred to as “Shadow CDS rates” using the ‘credit triangle’
s
approximation λ λ : risk-neutral default prob; s : CDS rate (premium, spread) and for RR = 0
(1  RR)
Using arbitrage arguments we find λ  s  y TB - y RB
(see Duffie Singleton (1999) and www.dersoft.com/recent.doc)
Options on CDS
Historical Transition Matrix of the year 2002
Rating at Year-end
Aaa Aa A Baa Ba B Caa Default WR
Aaa 86.82 7.75 0 0 0 0 0 0 5.43
Aa 1.38 82.23 12.12 0.14 0 0 0 0 4.13
Initial A 0 2.18 82.83 8.86 1.01 0.47 0.08 0.16 4.43
Rating Baa 0.17 0.17 2.46 79.47 7.55 2.04 1.87 1.19 5.09
Ba 0 0.18 0.18 2.39 72.38 13.26 2.03 1.47 8.10
B 0 0 0.14 0.41 2.71 72.9 9.76 4.88 9.21
Caa 0 0 0 0 0.34 3.42 56.85 27.74 11.64
(Table 5.5; Numbers in %)

Options on CDS
Aggregate Transition Matrix 1981 - 2003

Options on CDS
4) Rating Transitions cont.
We assume for the process of the CDS rate s initially at time t in class i,
si(t)
ds i (t)  μ i (t) dt  dm i (t)
Where m is a martingale that gives s some stochastics
How can we derive µ from a historical transition matrix???
We should consider that an obligor in class A has a µ and an obligor in class C

has a µ. A possible way to quantify this is
K
μ i (t)   (s j (t)  s i (t))λ ij
j1
Options on CDS

Applying
K
μ i (t)   (s j (t)  s i (t))λ ij
j1
to our example
Rating at
year end
j A B C D
Initial Rating i
A 0.7 0.15 0.1 0.05
B 0.1 0.6 0.2 0.1
C 0.05 0.15 0.65 0.15
D 0.0 0.0 0.0 1
we get for µi=A=

for µi=B=
for µi=C=
Options on CDS
How can we derive the value of an option on a CDS, VCDSO, from a historical transition matrix???
We can use the approach:
k
VCDSO (t)  V Qfee
(t)  p j (T) E QVfee [s j (T)  s*] t≤T
j1
VQfee : PV of all fee (s*VQfee) payments in a world conditional on no default ( proof Schoenbucher 2004)
pj : probability of the obligor finishing in rating class j
sj : fair forward default swap rate
s* : strike rate
If we assume that the dynamics of s are only driven be rating transitions, we get
k
(t)  p j (T) [s j (T)  s*]
j1
Applying
k
(t)  p j (T) [s j (T)  s*]
j1
to our example
Rating at
year end
j A B C D
Initial Rating i
A 0.7 0.15 0.1 0.05
B 0.1 0.6 0.2 0.1
C 0.05 0.15 0.65 0.15
D 0.0 0.0 0.0 1
with VQfee =1 and a strike s* of 3%, we get

Remark: We approximate sj(T) again as a “shadow rate” via its default prob: λs
VCDS0(i=A) =
VCDS0(i=B) =
VCDS0(i=C) =
Properties of approach
k _
(t)  p j (T) [s j (T)  s*]
j1
• No stochastic process! dmi in is zero.

ds i (t)  μ i (t) dt  dm i (t)
Dynamics of si depend only on the transition matrix.
• Historical drift rate and transition probabilities are extrapolated, but in reality
vary with the economic cycle!
Options on CDS
On the Recovery Rate
Source : Altman et al “The link between default and recovery rates” BIS working Paper 113, July 2002; www.BIS.org
Options on CDS
On the Recovery Rate cont.
Do current credit risk models incorporate this negative relationship  ?

0
RR
•The original Merton 1974 implicitly incorporates it via RR = N(-d1)/N(-d2)
•Extensions of Merton 1974, first time passage models (Black Cox 1976, Kim
Ramaswamy Sundaresan 1993, Longstaff Schwartz 1995, Briys de Varenne)
do not include the negative relationship
•Reduced form models (Jarrow Turnbull 1995, Jarrow Lando Turnbull 1997, Duffie
Singleton 1999, Hull White 2002, Kettunen Meissner 2004) implicitly include a
s
positive relationship! via the ‘credit triangle’ λ
(1  RR)
•Established credit VAR models, KMV (Moodys-KMV), Credit Metrics (JP Morgan),
Credit Portfolio View (McKinsey), CredidRisk+ (CSFP), Risk Manager (Kamakura)
do not include this negative relationship
Options on CDS
On the Recovery Rate – The compensation effect
If we price options on CDSs, should we explicitly include the relationship  ?

0
RR
Not really…
Since there is a compensation effect:
s
Default prob λ increases via λ hence V CDSO
(1  RR)
RR
CDS Option payoff (s(T) – s*) (1-RR) decreases, hence VCDSO
Empirical studies (Hull 2003) show that this compensation effect works well
Basics of Risk Management
Credit Risk
What is Credit Risk??
Read G. Meissner’s best-seller “Credit Derivatives” p. 1 - 250
Credit risk is the risk of a financial loss due to a reduction in the credit quality of a debtor.
There are principally two types of credit risk
Default risk is the risk that an obligor does not repay part or his entire financial obligation
Credit Deterioration risk is the risk that the credit quality of the debtor decreases
Is Credit Deterioration risk a problem?
How are Default risk and Credit Deterioration risk related??

Operational Risk
What is Operational Risk??
BIS Definition: The risk of direct or indirect loss resulting from inadequate or failed
internal processes, people and systems or from external events
(excludes legal, systemic (=systematic) and reputation risk)
Residual Definition: All risk, which is not market risk or credit risk
Types of Operational Risk
• Disaster Risk defined as external damage of a company’s property

Examples:
• Technology Risk defined as problems in a company’s technology lead to a deterioration

of the company’s operation
Examples:
Operational Risk
Types of Operational Risk cont.
• Knowledge Risk defined as the risk that a lack of knowledge leads to deterioration of a company’s
operation
Knowledge risk exists on all levels of a company’s hierarchy
Examples:
• Accounting Risk defined as accountants engaging in illegal accounting practices
Examples:
Regulatory action against Accounting risk:
Operational Risk
Types of Operational Risk cont.
• Criminal Risk defined as Criminal action that harms the organization

Examples:
• Political Risk defined as Changes in the political system or political

measures that harm the organization
Examples:
• Legal Risk defined as Legal action that harms an organization
Examples:
A quick look at Credit Risk
Some basic terms…
EL : Expected Loss (at a future time T)

N : Exposure at default (nominal amount); sometimes abbreviated EAD
LGD : Loss given default = 1 – RR; RR : Recovery rate
λ : Default Probability
So…
EL =
An example:
The investment in a Brazilian bond is $1,000,000. The expected default probability is

20%, the expected recovery rate is 30%. What is the expected loss?
EL =
Is Credit Risk normally distributed???
Let’s look at the historical Transition Matrix of the year 2002

Rating at Year-end
Aaa Aa A Baa Ba B Caa Default WR
Aaa 86.82 7.75 0 0 0 0 0 0 5.43
Aa 1.38 82.23 12.12 0.14 0 0 0 0 4.13
Initial A 0 2.18 82.83 8.86 1.01 0.47 0.08 0.16 4.43
Rating Baa 0.17 0.17 2.46 79.47 7.55 2.04 1.87 1.19 5.09
Ba 0 0.18 0.18 2.39 72.38 13.26 2.03 1.47 8.10
B 0 0 0.14 0.41 2.71 72.9 9.76 4.88 9.21
Caa 0 0 0 0 0.34 3.42 56.85 27.74 11.64
(Table 5.5; Numbers in %)
From this matrix, if we extract the initial rating A, we get…

Frequency
0.8
A
0.08
0.06
AA
0.02 BBB
0.01 AAA
D CCC B BB
30 40 50 60 70 80 90 100 110
Price
Conclusion:
(see www.dersoft.com/lnd.xls)
For investment grade bonds that have not been downgraded, we can assume that the credit
risk function is roughly inversely lognormally distributed.
Credit Return
Unexpected
Loss
mean
CAR = α σ
Loss Profit
-α
Later we will find how to determine α σ and consequently CAR…

Comparing Market Risk and Credit Risk
How are Market Risk and Credit Risk Distributed???
Market Return Credit Return
Loss 0 Profit Loss 0 Profit
(Compare slides around 150, 175; Book p. 139f, 200f)
Conclusion:
Credit Derivatives
What are Credit Derivatives??
Credit Derivatives: Financial Instruments designed to transfer Credit Risk (Default

Risk and Credit Deterioration Risk) from one counterpart to another
Legal ownership of the reference obligation is usually not transferred.
More technically, Credit Derivatives are financial instruments, whose value is

derived from the credit quality of an underlying reference obligation, which is
usually a bond or a loan.
Credit Derivatives
There are three main types of credit Derivatives:
Default swap is rather an insurance against default. A

Default swap creates a long or short position
in the credit exposure of an asset
TROR: Total (rate of) return swap. A TROR creates
a long or short position in a certain asset.
Credit Spread Products (Options, Swaps, and Forwards

on yield diff of 2 assets)
and a combination of the three types in
Synthetic Structures CLNs (Credit Linked Notes,

CDOs (Collateralized Debt Obligations), TPDSs (Tranched
Portfolio Default Swaps, TBDS (Tranched Basket Default
Swaps, CDO squared)
Credit Derivatives Products
Credit Derivatives
Default Swaps Credit Spread Synthetic

- Basket Swaps Total Rate of Products Structures
- Binary Swaps CDOs, CLNs,
Return Swaps -Options
- Contingent Swaps TPDs, CDO on
-Forwards
- RR Swaps -Swaps CDO, Single
Options on DS Tranche CDO
Synthetic Structures are not really a credit product by themselves,

but are simply bonds or loans with an imbedded credit derivative
Credit Derivatives Market
Credit Derivatives Products in 2002
Synthetic
structures
25.28%
Credit spread
options
0.70% Credit default
Total return swaps
swaps 72.72%
1.30%
The main reason for the dominance of default swaps are their
Total US Derivative Activity

Futures & Fwrds Swaps Options Credit Derivatives TOTAL
$70,000.00
$60,000.00
$50,000.00
$ $40,000.00
Bil
lio
ns
$30,000.00
$20,000.00
$10,000.00
$-
91Q4 92Q4 93Q4 94Q4 95Q4 96Q4 97Q4 98Q4 99Q4 00Q4 01Q4 02Q4 03Q1 03Q2 03Q3
Credit Derivatives Growth

900
800
700
600
500
400
300
200
100
0
98Q1 98Q3 99Q1 99Q3 00Q1 00Q3 01Q1 01Q3 02Q1 02Q3 03Q1 03Q3
Credit Derivatives Market – Risks and Challenges
• Concentration Risk :
10 global banks and broker/dealers hold of the short positions!
• Model Risk :
Most players have similar models and risk management assumptions.
Hence, a sell signal can trigger a mass sell off.
• Liquidity Risk:
The CDS and CDO market has outpaced the underlying cash bond
market. Hence the underlying bonds suffer a “Liquidity Black Hole”.
• Settlement Risk :
Most players have inadequate back office infrastructures and
backlogs with settling credit derivatives
• Disclosure :
Bank’s financial statements typically do not reveal if the credit
derivative is held as a speculative or risk reduction tool.
Default Swaps (also called Credit Default Swaps)
Premium (upfront or periodically)
Default Default
Swap Swap
Buyer Payment in case of default Seller
of a reference obligation
The Default Swap Buyer has a position in the credit quality of the
reference obligation. This means…
Hence, if the default swap buyer does not own the reference asset, he has a
position in the credit quality of the reference asset.
The Default Swap Seller has a position in the credit quality of the
reference obligation. This means…
Default Swaps cont.
Typically the default swap buyer owns the reference asset
Premium
Investor and Default

Default Swap
Swap Buyer $1 mio payment in case of Seller
default of reference obligation
Return of
$1 mio reference
obligation
Reference
Obligation
Issuer
Thus, in this case, the default swap buyer does not

have a speculative position in the credit quality of the
reference obligation. The default swap is now an
Features of Default Swaps
Premium

Default Swap
Return of
$1 mio reference
obligation
Reference
Obligation
Issuer
What correlation risk does the Investor have ???
Which default is worse for the default swap buyer???
Does the Investor still have operational risk???
Should we include the default risk of the Investor???

•What constitutes the default event?

-Must be clearly defined in the contract! ISDA 1999 Definitions (p16)
give 6 possible definitions of default: 1) Bankruptcy, 2) Failure to pay
3) Obligation Acceleration, 4) Obligation Default,
5)Repudiation/Moratorium, 6) Restructuring
No downgrade! Because “relatively few credit transactions” used
downgrade as a default definition
-Materiality clause: Debtor might have legal dispute with
the investor and refuses to pay coupon. This is not “material”
•What’s the Difference between a DS and Life Insurance??

As in an Option, Settlement can be physical or cash
If Cash Settled, the insurance seller pays N [1-RR-a)]

where N : notional amount, RR : recovery rate (=Final Price), a : accrued interest
Example 2.1a: The notional amount of a default swap is $1,000,000. The reference price is
100%, a dealer poll determines the final price of the reference bond as 20.00%. The last
coupon payment was 40 days ago and the bond has an annual coupon of 8%. What is the cash
settlement amount in case of default of the reference bond? It is
If Physically Settled, the insurance buyer gives the reference

asset to the insurance seller and the insurance seller pays
the settlement amount (=usually N)
Credit Swaps cont.
Premium

Default Swap
Return of
$1 mio reference
obligation
Reference
Obligation
Issuer
Does the Investor still have credit deterioration risk???
Does the Investor still have market price (= interest rate) risk???
What other risk does the Insurance buyer have??

Credit Swaps cont.
The approximate pricing of Default Swaps is quite straight forward, using
PV Default = PV Risk-free Bond – PV Risky Bond
Or if the swap rate is paid annually:
Default Swap rate pa = Risky Bond Yield – Risk-less Bond Yield
Example:
If the Risky Bond Yield is 12% and the risk-free (Treasury) Bond
Yield is 8%, what is the default Swap rate for one $100 par Risky Bond?
So a $4 Fee should be paid from the Default Insurance Buyer to the

Default Insurance Seller (see previous slide), annually
Credit Swaps cont.
Why does the Excess Yield reflect the annual price of a DS???
Because the only difference between a risky bond and

and risk-free bond is the credit risk! (assuming same
maturity)
This can be shown with an Arbitrage Argument:
Long a risk-free bond = Long a risky bond + Long a default swap
or stated in form of returns:
Yield on risk-free bond = Yield on risky bond - Default swap premium (pa) (2.1b)
Credit Swaps cont.
“Proof” of equation: Yield on risk-free bond = Yield on risky bond - Default swap premium (pa)
$1 mio
Investor Bond
A1 Seller
Treasury Bond, Yield 5%
$1 mio
Investor Bond
A2 Mexican Bond, Yield 8% Seller
$1 mio in
3% pa
case of
default
Default
Swap
Seller
The Risk profile and Returns of A1 and A2 must be identical, since both own a risk-free bond:
a) In case of default of the Mexican bond, A1
A2 can
b) In case of no default A1 and A2 make
c) In case of price decrease of Mexican Bond of 1% due to credit quality decrease, A 2 is on a mark to market basis:
The DS must increase since both investors have no credit risk; otherwise arbitrage
exists:
Credit Swaps cont.
If
Yield on risk-free bond > Yield on risky bond - Default swap premium (pa)
Example: The Yield on a risk-free bond is 6%, the Yield on a risky bond is 8% and
the annual DS premium is 3%. What is the arbitrage?
If
Yield on risk-free bond < Yield on risky bond - Default swap premium (pa)
Credit Swaps cont.
Equation
Yield on risk-free bond = Yield on risky bond - Default swap premium (pa)
is an approximation, since it is based on the assumptions:
• No counterparty default risk

• No default value of risk-free bond is par
(since par is paid in the DS in case of default, which must be
identical with the risk-free bond price, see 2 slides before red
highlight;
In case of no default, interest rate changes would have to affect
the risky and risk-free bond price the same for equation 2.1 to
hold, which is unlikely. Especially, for a bond close to default,
since in this case the yield is distorted, since the yield concept
assumes no default!)
• Accrued Interest
• Liquidity risk of risky bond
TRORs (Total Rate of Return Swaps)
Libor +/- Spread
TROR TROR
Payer Receiver
Total rate of return
(coupon + price change)
A TROR can be viewed as a non-funded position in an asset
- A TROR receiver is the underlying asset

- A TROR payer is the underlying asset
- Why doesn’t the TROR receiver just buy the underlying asset???
- Why doesn’t the TROR payer just short the underlying asst???
TRORs (Total Rate of Return Swaps)
Libor +/- Spread
TROR TROR
Payer Receiver
Who has the credit risk of the underlying???
What determines the Libor +/- spread???

TRORs (Total Rate of Return Swaps
A plain-vanilla TROR with the underlying looks as follows:
Libor +/- Spread
Investor and
TROR
TROR
Receiver
Payer TROR
(Price Change + Coupon)
Return of
$1 mio reference
obligation
 TROR
Reference
Obligation
Issuer
The TROR payment = Coupon + (Price Change), thus the TROR can be negative and positive
Bottom line:
What other risk does the Asset buy have??

TRORs cont.
Libor +/- Spread
Investor and
TROR
TROR
Receiver
Payer TROR
Return of
$1 mio reference
obligation
 TROR
Reference
Obligation
Issuer
Does the Investor still have credit deterioration risk???
Does the Investor still have market price (= interest rate) risk???
Does the Investor still have operational risk???
What other risk does the Insurance buyer have??

Features of TRORs
•What’s the difference between TRORs and Equity Swaps?
•What’s the difference between TRORs and Asset Swaps?
•In a TROR can it be that the receiver makes TWO payments?
•Does an Interest Rate Swap or a TROR have higher Credit Risk?

Relationship DS - TROR
An important relationship is:
TROR = DS + Market Risk
More precisely:
Receiving in a TROR = short a default swap + long a risk-free asset

(long credit quality + long market price = long credit quality + long market price) (Eq2.2a)
and…
Paying in a TROR = long a default swap + short a risk-free asset

(short credit quality + short market price = short credit quality + short market price)
TROR = DS + Market Risk cont.
Graphically equation (2.2a) can be expressed as follows:
BB rated Bond
Investor
TROR A1 Bank
Libor + x
Investor DS Premium 3%
A2 Bank
DS + $ 1mio in case
Long of Default
Risk-free $ 1mio Treasury

Bond
Asset
Insurance
Buyer
a) If the BB bond is upgraded to BBB (=credit risk), investor A1 will benefit

and A2 will benefit from an decrease in
, vice versa. So A1 and A2 both have credit risk.
b) If the interest rate level in the economy decreases (=market risk), A1 will benefit because
A2 benefits, because
So A1 and A2 both have market risk.
Reasons for TROR  DS + Market Risk cont.
BB rated Bond
Investor
TROR A1 Bank
Libor + x
Investor DS Premium 3%
A2 Bank
DS + $ 1mio in case
Long of Default
Risk-free $ 1mio Treasury

Bond
Asset
Insurance
Buyer
- Investor A1 has market risk

- The more liquid
- Funding cost of A2 depending on A2’s rating and rating of A1, which determines x
might be different
- It should be mentioned here that receiving Libor flat is profit neutral. This means that a trader
who receives or pays Libor has a zero profit on the trade, because Libor is considered the “fair” or
“current” market interest rate.
Credit Spread Products
As discussed earlier, credit derivatives can be categorized in

Default Swaps, TRORs and credit spread products.
Credit spread products consist of
• Credit spread options

• Credit spread forwards
• Credit spread swaps
Credit Spread Options
A credit spread is defined as
What determines the credit spread in an economy???
The reader should be careful with the terminology. In the field of exotic options, where spread options are
standard instruments, a call on a spread has a payoff of max (spread (T) – strike spread, 0), where T is
the option maturity. However in the field of credit derivatives, the payoff max (spread(T) – strike
spread, 0) is referred to as a credit-spread put. Thus, a credit-spread put buyer profits if the spread widens,
which means he profits if the yield of the risky bond increases or the price of the risky bond decreases.
Let’s list the payoffs to make things clear. Including a duration term, which is usually added to the
payoff, and the notional amount N, we get:
Payoff Credit-spread Put (T) =

Duration x N x max [credit-spread (T) – strike spread, 0] (2.5)
Payoff Credit-spread Call (T) =

Duration x N x max [strike spread – credit-spread (T), 0] (2.6)

Credit Spread Options
Example of a credit spread put payoff:
A credit-spread put option has a notional amount of $1

million. At option maturity the yield of a bond is 10%, the
Treasury bond yield is 5% and the strike spread is 2%.
The duration of the bond at option start was 3.5. What is
the payoff of a credit-spread put option?
Credit Spread Forwards
A forward is a contract between two parties to trade a certain asset at a

future date, at a price, which is determined today. In a credit-spread
forward contract the underlying asset is a credit-spread, defined as in
equation 2.4. The structure of a credit-spread forward contract on the
credit-spread of a bond can be seen in figure 2.12:
t0 t1 T
Forward trade Maturity date Maturity date
date, at which the of the forward of the bond
forward spread K contract
is agreed
The payoff of a credit-spread forward is similar to the payoff of a credit-spread option: The
payoff at time t1 is
Duration x N x [K – S (t1)] (2.9)

where Duration is defined as in equation (2.8), N is the notional amount, K is the agreed spread
at t0 (expressed in %) and S(t1) is the actual spread at t1 (also expressed in %).
Credit Spread Forwards
Example 2.6a: An investor believes the credit quality of a bond will decrease
and hence the relative price of a bond will decrease. He sells a credit-spread
forward contract with an agreed spread K of 2%. The notional amount N is
$1,000,000 and the duration of the bond at trade date is 3.5.
The credit quality of the bond price, however, increases so that the yield
spread decreases to 1%. What is the loss of the credit-spread forward seller?
Credit Spread Swaps
To begin with, the reader should not confuse default swaps (DS) also termed credit default
swaps (CDS) with credit-spread swaps. As mentioned above, a default swap is the most
popular credit derivatives product and can be viewed as an insurance against default of the
underlying asset, if the underlying asset in owned.
A swap is In a credit-
spread swap, party A pays a fixed credit-spread rate, and party B pays the 6 months Libor, as
seen in figure.
What is the difference between a forward and a swap???
Fixed Credit Spread 3%
Credit-Spread Credit-Spread
Fixed Rate Fixed Rate
Payer 6ML Receiver
What view on the credit spread does the fixed rate payer have???
Recovery Rate Swaps (RR Swaps)
The default swap buyer typically does not receive the recovery rate. (Effectively he pays it
since he receives a negative cash flow.)
Hence he has recovery rate risk. This can be eliminated with a RR swap. Graphically:
Premium s
Default
Investor and
Swap
Default
Seller
Swap Buyer
Payoff: N (1-RRr) c
RR
counterparty
Conclusion:
Constant Maturity Credit Default Swaps (CMCDS)
Constant maturity default swaps have their origin in constant

maturity interest rates swaps (CMS).
Let’s look at a CMS (also called ‘yield-curve swap) first:
6ML 6ML 6ML 6ML
t0.5 t1 t1.5 t2
t0
3-year 3-year 3-year 3-year

CMS CMS CMS CMS
rate rate rate rate
Application of CMS:
Pricing of CMS: Quite straight forward, but typically convexity adjustment for the forward rate
necessary
Constant Maturity Credit Default Swaps (CMCDS) cont.
In a constant maturity default swap, the premium payment is a long term, floating
rate, called CMCDS rate. The CMCDS rate is a floating long-term CDS rate.
Example of a 2-year CMCDS with a 10-year CMS rate, fixed and paid semiannually:
Payoff in case
of default
T0 6m 6m 6m TN
τ
ai
10-year
10-year
CDS 10-year
CDS
rate CDS
rate
rate
CDS period
Application:
Constant Maturity Credit Default Swaps (CMCDS) cont.
Pricing of CMCDS:
Fairly complex. Although closed form solution exists (Brigo 2005). The approach
includes a correlation between the short term (tj – tj-1) CDS rate and the long term
CMCDS rate. Calibration of many inputs tough.
The Application of Credit Derivatives
The five main types of applications are:
• Hedging
• Yield Enhancement
• Cost Reduction / Convenience
• Arbitrage
• Regulatory Capital Relief

Hedging
Definition Hedging : - Reducing Risk

- Entering into a second trade to
reduce the risk of an original trade.
What types of risk do we currently differentiate??

Hedging with Credit Derivatives
Spread
Optional of Fixed??
Hedge
Investor
Counterpart
payoff
$1 mio Mexican
Bond
Mexican
Bond
Seller
We should hedge with a future or swap if we are VERY certain that the Mexican
bond will decrease in credit quality
We should hedge with an option if we are not so certain that the Mexican
bond will decrease in credit quality. In
this case we will participate in an credit
quality improvement of Mexico!
Achieved by “assuming credit risk”, i.e. “selling protection” as a

default swap seller.
Users of Yield Enhancement are investment banks, hedge funds,

third party asset managers, and individual investors and speculators.
Typically in Synthetic Structures, the investor assumes credit risk

and receives an above-market premium:
2. The Application of Credit Derivatives
Risk-free
Asset
Seller
Senior Tranche
(exposed to
Cash + 6% - 9% of defaults)
DS Premium
Coupons
..
DS Premium Cash Mezzanine Tranche
Basket
of 125 (exposed to
Assets SPV Coupons 3% - 6% of defaults)
Payment in case
of default ..
Junior Tranche
(exposed to
first 3% of defaults)
Example of a tranched basket default swap (TBDS) , which is

a type of CDO (collateralized debt obligation)
DS : Default Swap; SPV : Special Purpose Vehicle
(Structure similar to European iTraxx and American CDX index
portfolios)
Many other yield enhancement strategies with credit derivatives exist as:
Covered credit-spread put selling strategy to exploit a static or an increase in

credit quality, Covered credit-spread call selling to participate in a static or
slight decrease in credit quality, Shorting a digital credit straddle to exploit a
ranged credit quality, a Credit-spread forward strategy exploiting a possible
flattening or steepening of the credit curve, or Selling a credit-spread straddle
in order to participate in a decrease of the credit-spread implied volatility.
• Cost Reduction
Often it is cheaper to use credit derivatives than the cash

market, an example:
An investor want to short a bond. This can be done conveniently
in a TROR (total rate of return swap):
Libor +/- Spread
TROR TROR
Payer Receiver
• Convenience
Credit derivatives can maintain a good bank – client relationship:
Suppose an investment bank reaches its credit limits for a client. Without
credit derivatives, it would have to sell the credit in the often rather illiquid
secondary cash market. If the client discovers the sell, he will most likely be
upset about his debt resurfacing. It might also be required that customer
consent is necessary to transfer the debt and the customer refuses to give
that consent. If selling the debt is not possible, the bank would have to
reject further lending to the client, naturally harming it’s bank – client
relationship.
Credit derivatives can solve the problem. A bank can simply hedge the
credit of a questionable client with a default swap, effectively writing it of
their balance sheet and opening new credit facilities for the client. In most
cases, the client does not even notice that his credit line was full and had to
be synthetically extended. Thus, the use of credit derivatives can discreetly
maintain a good bank – client relationship.
• Arbitrage
Definition Pure Arbitrage: A profit which is uncorrelated to movements in the

underlying price, yield or spread (ex: Cash and Carry, Replication strategies)
Definition Risk Arbitrage: An assumed profit, which involves price, yield or spread
risk (ex: ‘Take over arbitrage,’ ‘Yield curve arbitrage’ or ‘statistical arbitrage’)
Appliers of arbitrage with credit derivatives are typically investment banks and
hedge funds, since financial expertise and accessibility to information is necessary.
The cause for arbitrage lies in the fact that many credit derivates and credit
derivatives structures can be replicated with cash instruments:
• Arbitrage – An Overview
Pure Arbitrage Strategies in the Credit Market

1) Synthetical versus cash (ex: credit call and put versus cash bond)
2) Yield on risk-free bond = Yield on risky bond - Default swap premium
3) TROR (Total Rate of Return Swap) = Default Swap + Market Risk
4) Repo = Receiving in a TROR + Sale of the Bond
5) Equity puts  Default swaps
Popular Risk Arbitrage Plays
• Equity - Credit spread (typically short equity, long credit)

• Calendar Spreads (ex: Long 5-year iTraxx, short 10-year iTraxx)
• Relative value plays (ex: short iTraxx, long one particular credit in the index)
• Implied correlation plays (ex: Long equity tranche if implied Corr is
expected to increase)
Arbitrage with Credit Derivatives
First, the simplest form of Funding Arbitrage involves no credit derivatives
$ 1 mio $ 1 mio
Lender AAA BBB
Libor - 20 Libor + 30
Conclusion:
Pure Arbitrage Strategies: Excess Yield versus DS Premium
$1 mio
Investor Bond
A1 Seller
Treasury Bond, Yield 5%
$1 mio
Investor Bond
A2 Mexican Bond, Yield 8% Seller
$1 mio in
3% pa
case of
default
Default
Swap
Seller
For a discussion, see around slide 130…

Pure Arbitrage Strategies
In the credit-spread option market, often credit-spread puts are slightly more
expensive that credit-spread calls, since puts protect against credit deterioration, thus
demand is high. Hence, an investor can sell a 1-month credit-spread put and buy a 1-
month credit-spread call at a high identical strike of 60 basis points above Libor,
whereby the premiums add up to zero. In addition, the investor can sell the
underlying bond 1-month forward at Libor + 50 basis points, hence achieving an
arbitrage of 10 basis points, as seen in the figure below:
Profit
Forward short
bond position
Arbitrage
10
Spread over
0
60 Libor
Long credit spread call
Synthetic long Short credit spread put

forward bond position
Loss
A Repo (Repurchase Agreement)
At t0:
Bond
Cash-
Cash-
$ 1 mio Lender,
Borrower,
who does the
who does
Reverse-
the Repo
Repo
At T:
Cash-
Cash- $ 1 mio Lender,
Borrower,
who does the
who does
Reverse-
the Repo 6% Repo
Bond
In practice, the interest rate (=Repo rate) paid by the cash borrower (6%), is usually
expressed as a price, i.e. a dollar amount at which the bond is purchased back
If the cash borrower defaults on his loan, the lender simply keeps the bond
Cash borrower often find lower rates in the Repo market that the money market
Coupons of the bond are passed back from the cash lender to the cash borrower during the Repo
Pure Arbitrage Strategies: TROR + Sale of risky Bond = Repo (of risky Bond)
Bond in t0
$1 mio
B
Repo: A1
does the
does the
Reverse
Repo Libor +/- Spread Repo
Bond in t1
TROR
TROR + Libor +/- Spread
TROR
Sale of risky Bond: A2 receives Payer
the TROR and Bond and Bond
sells the Bond Buyer
$1 mio
Conclusion: Let’s assume both A1 and A2 borrowed the bond. Then the Profile of A 1 and A2 are identic
In the Repo A1 has a loan against Libor +/- Spread, and has the no bond price risk
Same is true for A2, since the 1st the 3rd leg cancel (A2 has no exposure to the bond sale,
since it is assumed it had borrowed it!!)
Risk Arbitrage: Equity Puts versus Default Swaps
Popular Strategy: Long equity put and long DS
Is basically a play on the recovery rate…
A put may pay the total K – (S =0) is case of default, whereas the DS
pays (Notional – recovery rate)
Risk Arbitrage: Equity Puts versus Default Swaps
Another Popular (Hedge Fund) Strategy:
Short Equity (e.g.
and
Long debt (e.g. CDS)
This went nicely wrong in 2005, when Kirk Kerkorian bought GM

(equity increased) and GM got downgraded (debt decreased)…
Risk Arbitrage: Correlation Trading
Flavor of our time…
Not really new: Quanto options and Multi-assets trade since the mid-1990s…
There are 2 main theoretical approaches when modeling correlation

Correlation Trading
Modeling default correlation:
A) Discrete Correlation: If two companies’ default correlation (usually

derived from the equity correlation) is ρ(r , c), the joint probability of
default r ∩ c can be shown to be
 (r ∩ c) = ρ(r , c) [λ r  (λ r ) 2 ][λ c  (λ c ) 2 ] + r x c
If the correlation coefficient ρ(r , c) = 0, it follows that
B) Copula Approach: A way to represent a joint distribution function from

their marginal distributions. The popular bivariate Gaussian copula is:
C(u A , u B )  M [N -1 (u A ), N -1 (u B ), ρ]
Bivariate Inverse of Risk u of correlation

cumulative univariate Variable parameter
normal cumulative A for risks
distribution normal uA and uB
distribution
0   1
(see model www.dersoft.com/copula.xls)
More on Default Correlation
If two companies’ default probabilities are independent, the joint probability of default is
the product of the individual default probabilities
simply .
 (r ∩ c) = r x c
So if the default probability of company r, r, is 2% and the default probability of company c, c, is
3%, the joint probability of default, in case the default probabilities of the companies are
independent is
If two companies’ default correlation (usually derived from the equity correlation)
is ρ(r , c), the joint probability of default r ∩ c can be shown to be
If the correlation coefficient ρ(r , c) = 0, it follows that

More on Default Correlation cont.
Example of equation
If the default probability of company r, r = 5% and the default probability of company c, c =

1% and the default correlation coefficient is 0.2, what is the joint default probability of r and c?
 (r ∩ c) =
Comparing this result with the joint default probability in case the default of r and c
is not correlated, which is we see that
Correlation Trading
Empirical Findings:
1) Default correlations are positively dependent on default rates

i.e. both increase in a recession and decrease in an expansion (Hull; Li, Meissner)
2) Recovery rates are negatively dependent on default rates (Hull)
3) Industries that have relatively high default rates tend to exhibit

high default correlations with other sectors (Li, Meissner)
4) Sectors with high return volatility tend to show high default

dependence to macro economic factors (Li, Meissner)
5) No empirical evidence found of a direct relationship between

equity correlation and default correlation! Use asset correlation?
Correlation Trading
The Market
First-to-default baskets and CDOs are credit derivatives structures where the
underlying is a basket of names. Hence correlation is crucial…
These structures show a high resemblance to the plain vanilla option market
with ‘implied correlation’ ‘correlation smile’, delta, gamma, vega etc
Implied correlation is the uniform asset correlation number that makes the fair
or theoretical value of a tranche equal to its market quote.
Correlation smile refers to the fact that junior and senior tranches are priced
With a higher correlation than mezzanine tranches
Correlation Trading
First-to-default baskets
Whereas a standard Default Swap protects the buyer against default of a single
asset, a First-to-default basket swap protects against default of any asset in the basket.
Naturally, the of the assets in the basket are a crucial factor in

determining the premium (also called spread) of the first-to-default basket swap.
Correlation Trading
CDOs
A CDO (Collateralized Debt Obligation) consists of tranches with

different default risk, originating from a reference basket.
Risk-free
Asset
Seller
Senior Tranche
(exposed to
Cash +
6% - 9% of defaults)
DS Premium
Coupons
..
DS Premium Cash Mezzanine Tranche
Basket
of 125 (exposed to
Assets SPV Coupons 3% - 6% of defaults)
Payment in case
of default ..
Junior Tranche
(exposed to
first 3% of defaults)
DS : Default Swap; SPV : Special Purpose Vehicle

(Structure similar to European iTraxx and American CDX index portfolios)
iTraxx and CDX Mechanics
The iTraxx (Europe) and the CDX (USA) are families of indexes,
who’s underlying are CDS prices.
The iTraxx IG (investment grade) and the CDX IG comprise CDS prices on
125 equally weighted investment grade names. They are tranched and hence
. One difference is that no cash is invested. Just the prices of
the iTraxx and CDX is paid or received (see about 4 slides earlier).
As with any index, the composition of the index is reviewed periodically and
updated.
iTraxx and CDX Mechanics
CDX
Upfront Annual Annual Annual Annual Average
0%-3% 3%-7% 7%-10% 10%-15% 15%-30%
5-year Quotes 40.02% 295Bp 120Bp 43Bp 12.43Bp 60Bp
iTraxx
Upfront Annual Annual Annual Annual Average
0%-3% 3%-6% 6%-9% 9%-12% 12%-22%
Quotes from August 24, 2004
Equity or Mezzanine Senior Super Senior

Junior Tranches Tranche Tranche
Tranche
For the Equity tranche, 500 BP pa “running basis” is

added.
What do these quotes mean??
The 295 BP means that the buyer of the trance pays

Correlation Trading
First-to-default baskets
Some intuition…
If the default correlation of the assets in the basket is 1, the premium s is:
(The buyer wants to be protected against…
It the default correlation of the assets in the basket is 0, (they are

totally independent), the premium s is roughly
(The buyer has to protect against….

Correlation Trading
CDOs
For valuing the individual tranches of a CDO, correlation is key:
The junior tranche owner, as the FTD The senior tranche owner, (= cat with 9 lives)
owner (= cat with 1 life) wants a wants , hence a
or a correlation of defaults. In this case, the Prob
correlation. In this case the Prob of the first of 10th default is low and hence the coupon or
default is low and hence the coupon or DS DS premium is low.
premium is low.
Correlation Trading
Impact of tranche correlation on tranche premium
Tranche Premium or coupon

or sometimes badly “value”
First-to-default or
equity tranche owner
Mezzanine tranche
10th-to-default or
Senior tranche owner
Correlation
0 50 100
Evenly distributed Clustering of
defaults defaults
What about a mezzanine tranche?? Might be (McGinty et al 2004

CDO Mechanics
In case of default of a reference asset, an index seller has to make payments (payoff) of
N p / (Lu – Ld)
N : notional amount, p : percentage payment, L : accumulated loss in the CDO
(L  Ld) if Ld  L  Lu
Formally: 
p (Lu - Ld) if L  Lu Ld : lower loss limit (e.g. 3%)
0 otherwise Lu : upper loss limit (e.g. 6%)

Additionally, if a loss occurs, the coupon of the index seller s (also called spread) earns is
only
s N (Lu – Lr) / ( Lu – Ld)
where Lr is the accumulated capped loss, defined Ld<Lr<Lu, capped at Lu; if Lr < Ld, the coupon remains unchanged
Example 1: An investor buys a mezzanine tranche with a 3% lower and 6% upper loss limit on
$1,000,000 notional. He receives a spread s of 5% pa, hence $50,000.
4% of the assets in the CDO default.
The payoff the investor has to make is
N p /(Lu – Ld) =
The coupon (spread) that the investor receives is only s N (Lu – Lr) / ( Lu – Ld) =
Example 2: Same as example 1, but 7% of the reference assets in the CDO default.
The payoff the investor has to make is
N p / (Lu – Ld) =
The coupon (spread) that the investor receives reduces to s N (Lu – Lr) / ( Lu – Ld) =
Equity Default Swaps (EDS)
Mechanics:
Def: An EDS is a financial instrument that transfers the risk

of a big stock decline from one counterparty to another
Premium (upfront or periodically)
EDS EDS
Buyer Seller
Payment in case of decline
of a reference stock
• Typically ‘Equity Default’ occurs if the underlying stock drops by more than
• In the case of ‘Equity Default’ the payment of the EDS seller is typically
An EDS is an equity – credit hybrid, since for
More specifically:
Credit default equity default
Equity default is easier to than credit default
Using option theory, an EDS is actually a
Far out-of-the-money down and in digital put

Application of EDS:
Pretty much the same as for credit derivatives:

(Theoretical CEV model) EDS prices as a function of rating class, August 2004
Does a CDS or EDS have a higher spread (premium)?
EDS spread vs CDS spread of the Euro (Theoretical) CDS –EDS ratios
Stoxx 50 (highly rated), August 2004 for different initial rating classes
Popular CDS – EDS strategy:
•Long CDS (= short credit) - Short EDS (= long stock):
Scenario 1: No equity default and no credit default →
Profit =
Scenario 2: equity default and credit default →
Profit if RR (CDS)
Scenario 3: equity default but no credit default →

Loss of
Pricing of Equity Default Swaps (EDS)
• Pricing it as a (far-our-of-the-money) down and in put
Problem:
The model with jumps produces EDS –CDS ratios of about

1:1, which are not in line with the market.
• Swap valuation techniques, as a

CDS :
Calculate the PV(fee leg) and the PV(payoff leg).
Subtract the two legs, set them to 0, solve for fair EDS rate
s.
(Albanese 2004)
• Regulatory Capital Relief
Total Capital (Tier 1 & 2)
Credit Risk  12.5 x (Market Risk  Operational Risk)
 8!
Example 4.26: Bank X has combined Tier 1 and Tier 2 capital of $3 billion. Bank X also
has a credit risk charge of 10 billion, a market risk charge of 1 billion and an operational
risk charge of 2 billion. Following equation (4.6), we derive
3
 6.32%
10  12.5 x ( 1  2 )
Since the BIS has set the combined minimum ratio at 8%, the ratio in this example is
too low. Hence the bank has to either increase its Tier 1 or Tier 2 capital, or reduce its
credit, market or operational risk requirement via reducing these risks. The risks can
be reduced by either selling risky assets, entering into trades that net the original
trades or, as discussed in detail, with derivatives.
Pricing Default Swaps
More difficult than other derivatives, since the underlying are
often illiquid or not traded at all in the case of
Therefore it is difficult to model the underlying (build a tree)
Pricing credit derivatives is also problematic because

Especially, since a company typically only defaults once,
empirical data on the default of a solvent company is typically
unavailable. To overcome this obstacle, it is often assumed that
companies in the same credit category and sector display similar default
dynamics and properties.
In addition, there are

There can be internal causes as mismanagement, incompetence or
fraud; and external causes as a recession or stiff competition.
Typically default is caused by a combination of factors, whose
correlation has to be integrated into the pricing model.
The Pricing of Credit Derivatives
Pricing Credit Derivatives
In Practice Structural Reduced Form

-via Asset Swaps
-via Replication
Models Models
(based to Merton (1974)) (share Martingale framework
(Hedging) with Merton (1974))
Extension:
First time passage models - Jarrow Turnbull (1995)
-The Black Cox (1976) - Duffee (1996)
-Kim, Ramaswamy, and - Jarrow Lando Turnbull (1997)
Sundaresan (1993) - Duffie Singleton (1999)
-Longstaff-Schwartz (1995) - Das, Sundaram (2000)
-Briys - de Varenne (1997) - Hull White (2001)
- Jarrow, Yildirim (2002)
- Kettunen, Ksendsovsky,
Meissner (2003 )
What determines the Price of a Default Swap??????
Input variables for deriving the premium s of a credit derivative
1) Default probability and credit deterioration probability of the reference asset
2) Default probability and credit deterioration probability of the credit derivatives seller
3) Correlation between 1) and 2) Premium
4) Volatility of the underlying reference asset
5) Volatility of the credit derivatives seller Investor and Default
Default Swap
6) Correlation between 4) and 5)
7) Maturity of the credit derivative default of reference obligation
8) Expected recovery rate of the reference asset
Return of
9) Expected recovery rate of the credit derivatives seller $1 mio reference
10) Return of the reference asset (e.g. coupon of the reference bond) obligation
11) Risk-free interest rate term structure used to discount future cash flows
12) Default probability of the credit derivatives buyer in case of periodic credit
derivative premium
13) Expected recovery rate of the credit derivatives buyer in case of periodic credit
Reference
derivative premium Obligation
14) Correlation between the default probability of the credit derivatives buyer and the Issuer
reference asset in case of periodic credit derivatives premium
15) Market risks (as interest rate risk, currency risk, commodity risk and stock price risk)
and the correlation between market risk and credit risk
16) Operational risks (e.g. legal risks, documentation risks or settlement risks), which
might endanger the enforceability of the payoff and the correlation between
operational risk and credit risk
17) Liquidity of the credit derivative
18) Liquidity of the underlying reference asset
See www.dersoft.com/
19) BIS risk weight of the credit derivatives seller
20) Urgency of protection (e.g. is an immediate credit deterioration expected or does the
dslmmkkmcopula.xls
protection free up credit lines to enable further business with a client)
21) Transaction costs
In the following let`s discuss
- Pricing in Practice
- Pricing on Arbitrage Arguments (already done)
- Pricing by replication (hedging)
- A simple tree
- Structural Models
-Reduced Form models
Jarrow Turnbull (1995), Jarrow Lando Turnbull (1997)
Duffie Singleton (1999), Hull White (2000)
As discussed, in an arbitrage free market the DS should be approximately the

difference between the yield of the reference asset and the yield of the risk-free asset.
In trading practice DS`s often trade based on the liquid asset swap market
What is an asset swap???
An asset swap is
The fixed rate in an asset swap is based on

Let’s assume the (10-year) market swap rate is 4%, which reflects the risk-free swap rate.
We then have an asset swap for a BB-rated bond with a 6% coupon:
?
Investor Swap
counterpart
?
Asset 6%
$1 mio coupon
Mexican
Bond
The coupon of the bond (= the fixed rate in the swap) reflects the credit risk of the bond. Why???
If an investor wants to ‘asset swap away’ the (future) credit risk he pays the level of that risk, the coupo
Does the investor still have Mexican credit risk???
Does the investor have market risk??
The historical Yield-Spread
How can we exploit this???

Play the spread:
Cash Cash
Investor is
Funding A rated
long
Provider Asset
the basis
Libor Libor + x Bp
Payment if
Default Swap
Premium d Bp A-rated
Asset defaults
Default
Swap
Seller
‘x’ represents the asset swap spread; ‘d’ represents the default swap premium
For a Libor flat funding, the arbitrage free condition is
Therefore:
Several Factors jeopardize the equation x = d. The main factor is counterparty

default risk. This is bigger in a default swap than in an asset swap, since in an
asset swap, cash flows of similar magnitude are exchanged.
In practice derivatives are often priced by replicating the derivative in the
cash market. The replication can serve as a hedge.
“I trade it where I can hedge it – plus my margin”
Let`s look at a simple DS Swap:
3% pa
Bank A
buys Bank B
protection sells
1 mio in case protection
of default
How does Bank A hedge his long DS position??
How does Bank B hedge it`s short DS position??

The cost of the hedge of Bank A and Bank B determines the DS Price:
Bank A hedges it`s long DS position by borrowing 1 mio and purchasing the Mexican bond:
Libor + w
Lender Bank A
$1 mio
$1 mio Libor Mexican

+x Bond
Mexican
Bond
The income from the hedge for the Bank A is:
How does the hedge work in case of physical settlement??

If the Mexican bond defaults, Bank A delivers it via the DS, receives 1 mio and returns
1 mio to the lender.
- Pricing by Replication (Hedging)
Bank B hedges its short DS position by borrowing the bond in the Repo market
and selling it short: $1 mio
Bank B Market
Libor + x
Mexican
Lending Bond
$1 mio rate Mexican
Libor Bond
-y
Bond Lender
in Repo
Market
The cost of this hedge for the Bank B is:
How does the hedge work in case of physical settlement??

Following the cost of the 2 hedges, the premium of the DS has to be in the range of
x-w and x+y
Example: A DS buyer (Bank A) has a financing rate of Libor +25Bp (w=25Bp). The
reference bond pays Libor + 300 Bp and the Repo rate on the reference bond
for the DS seller (Bank B) is Libor – 50 Bp (y = 50Bp). In which range should be DS trade?
and
So the income of the hedge for the DS buyer (Bank A) is 275 BP and the cost
of the hedge for the DS seller (Bank B) is 350 Bp.
The DS price in practice will be determined by negotiation. Let`s assume it is 300 Bp.
(as on slide 99)
The DS price in practice will be determined by negotiation. Let`s assume it is 300 Bp.
(as on slide 99)
Therefore, Bank A who only receives 275 Bp in his hedge and Bank B, who pays
350 Bp in it`s hedge BOTH lose money on their aggregate DS and hedge position!!!
So how can the DS premium of 300 Bp be explained???

Bank A might be desperate for a DS hedge, e.g. because it wants to expand the credit line
for the reference entity,and not sell the credit in the market, so he is willing to pay a high price.
Bank B might be a speculator and happy with 275 Bp DS premium
Diversification for Bank A and Bank B
Due to low liquidity and bad rating, a DS might still be more favorable for either bank than a replication
If a Bank has a low funding cost, both might break even. What is the breakeven
funding cost for Bank A in the above example?? Libor – 50Bp
The off-balance sheet feature makes a DS more attractive to both DS counterparts

than a cash replication
In the DS market, only ONE transaction in necessary. The replication involves two,
which means two costly bid-offer spreads and double the administrative costs
What determines the Price of a Default Swap??????
Input variables for deriving the premium s of a credit derivative
1) Default probability and credit deterioration probability of the reference asset
2) Default probability and credit deterioration probability of the credit derivatives seller
4) Volatility of the underlying reference asset
5) Volatility of the credit derivatives seller
7) Maturity of the credit derivative
8) Expected recovery rate of the reference asset
9) Expected recovery rate of the credit derivatives seller
10) Return of the reference asset (e.g. coupon of the reference bond)
11) Risk-free interest rate term structure used to discount future cash flows
12) Default probability of the credit derivatives buyer in case of periodic credit
derivative premium
13) Expected recovery rate of the credit derivatives buyer in case of periodic credit
derivative premium
14) Correlation between the default probability of the credit derivatives buyer and the
reference asset in case of periodic credit derivatives premium
15) Market risks (as interest rate risk, currency risk, commodity risk and stock price risk)
and the correlation between market risk and credit risk
16) Operational risks (e.g. legal risks, documentation risks or settlement risks), which
might endanger the enforceability of the payoff and the correlation between
operational risk and credit risk
17) Liquidity of the credit derivative
18) Liquidity of the underlying reference asset
19) BIS risk weight of the credit derivatives seller
20) Urgency of protection (e.g. is an immediate credit deterioration expected or does the
protection free up credit lines to enable further business with a client)
21) Transaction costs
A simple tree
Building a tree of the underlying bond or loan is difficult, because bonds are often illiquid
and loans don’t trade at all!
The price tree for a risky 2-period bond is usually constructed as:
RR 1
RR(1+r)
0  : Default Probability
RR : Payoff in Default or Recovery Rate

RR
1
1-0
1-1
The big question is: How can we find  and RR??

The Bond Price Cash Flow Tree:
If r is the risk-less rate, than an investment of $1 at the end of year one is 1+r
Example: $1 invested at 10% for one year =
Due to equation: Default Swap rate pa = Risky Bond yield – Risk-less Bond Yield
an investor, who invests in a risky bond receives: the risk-less yield + the DS premium pa, thus 1+r+s
where s is the DS premium
Thus, we derive a 2-period Risky Bond Cash Flow Tree
RR (1 + r0 + s0)
0
1 RR (1 + r1 + s1)
(1 + r0 + s0)
1-0
1-1
(1 + r1 + s1)
RR (1 + r0 + s0)
0
RR (1 + r1 + s1)
1
(1 + r0 + s0)
1-0
1-1
(1 + r1 + s1)
In an arbitrage free world, the risk-less return 1+r must equal the risky return
Thus, at the end of year one we have
Solving equation (1) for 0, we get
0 =
Example: The 1-year risk-less rate is 5%, the 1-year DS premium 3% and the
recovery rate 60%. What is the probability of default at the end of year 1?
(1+r0+s0)RR (1+r0+s0)RR
0 0
(1+r1+s1)RR
1 1
1
(1+r0+s0) r0+s0
1-0 1-0
(1+r1+s1)
1-1
In order to derive 1 , the risk-less profit at the end of year 2, (1+r0)(1+r1), must equal
(1 + r0) (1+r1)=
Solving for 1 we get:

 (1  r0 )(1  r1 )   0 RR (1  r0  s 0 )(1  r1 ) 
   (r0  s 0 )(1  r0 )  1  r1  s1
 (1   0 ) 
1 
RR (1  r1  s1 )  1  r1  s1
Example: The 1-year and 2-year risk-less rate are 5% and 6% resp., the 1-year DS premium 3%,
the 2-year is 3.5% and the recovery rate 60%. What is the probability of defaulting at the
end of year 2? With 0 = 6.94% we get
www.dersoft.com/binomialdefaultmodel.xls
Thus, we have a 2-period Risky Bond Cash Flow Tree
RR (1 + r0 + s0)
6.94%
RR (1 + r1 + s1)
7.99%
(1 + r0 + s0)
1-6.94%
1-7.99%
(1 + r1 + s1)
To derive the upfront DS premium, we discount the probability weighted (known) DS premiums back to today
3%
0 /(1+r0)
1 /(1+r1) 3.5%
3%
(1-0 )/(1+r0)
(1-1 )/(1+r1)
3.5%
3% 0 = 6.94%
0 /(1+r0)
1 = 7.99%
1 /(1+r1) 3.5% r0 = 5%
3%, r1 = 6%
(1-0 )/(1+r0) 3.30%
(1-1 )/(1+r1)
3.5%
From t2 to t1:
From t1 to t0:
There are 2 main types of models to price credit derivatives:
- Structural Models
- Reduced Form Models
Structural Models
Structural Models investigate the capital structure of a company in order to determine

the probability of default.
Structural Models were founded by Merton (1974). Merton used the simple equation
Equity = Assets – Liabilities.
Merton showed, that equity holders have a call option on the assets of the company:
If the company does well, the assets will exceed the liabilities and the equity will
increase with unlimited potential. If the company does badly and liabilities exceed
assets, the company goes bankrupt. In this case the equity holder lose their equity.
The Merton 1974 Model
 qT  rT
C Se N(d1 )  K e N(d 2 ) Se  qT 1
ln(  rT )   2 T
d1  Ke 2
C : Call price; S : Stock price; K : Strike price  T
d 2  d1   T
N (  d 2 )  1  N (d 2 )
E  V e  qT N(d1 )  D e  rT N(d 2 )
N (  d 1 )  1  N (d 1 )
E : Equity value V : Asset value; D : Debt value
Structural Models cont.
Value of
Equity E
Time value
Intrinsic value
max(V – D, 0) Asset
D value V
Equity holders have a claim on the assets of a company: If the asset value V increases, the equity value
E will increase with unlimited upside potential. On the downside, if the debt D exceeds the assets V, the
company will go In this case the equity holders will take the remaining assets to repay part
of the debt, the equity value being zero. This unlimited upside potential and limited downside risk is an
essential option criteria and is reflected in the time value as seen in the above figure.
A well known property of the Black-Scholes model is that the probability of exercising a
call option is N(d2). Therefore, the probability of not exercising the option i s N(-d2). Not
exercising the equity option means that the debt D is bigger than the assets V. This is the
case of bankruptcy. Therefore, the probability of default in the Merton framework is N(-
d2). Let’s derive this default probability in a numerical example:
The assets of company X are currently worth $1,300,000. In 90 days company X has to repay $1,000,000 in
debt. The expected volatility of the assets is 30% and the risk-free interest rate is 5%. What is the
probability of default in 90 days on the basis of the Merton model?
The probability of default is
N(-d2) = N
The value of credit risk and the probability of a company’s default in Merton’s model can
also be found by expressing credit risk with the help of a put option on the assets of the
company: The equity holders can hedge the credit risk by buying a put on the assets with
strike D, the put seller being the asset holders. In case of default, i.e. V < D, the equity
holders will deliver the assets to the asset holders, the loss for the asset holders being D –
V. Thus, the put option can be expressed as in equation (5.18)
P0 = - V0 N(-d1) + D e-rT N(-d2)
V0 1
ln(  rT
)  σ 2V T
where d1 = De 2 and d2 = d1 - σ V T
σV T
P0 : current value of a put option on the company’s assets V with strike D; other variables
as defined in equation (5.9)
The equity holders will exercise the put option in equation (5.18) at time T if D > V. In the
Merton model, this is the case of bankruptcy. Thus, the probability of exercising the put,
which is N(-d2), is again the probability of default.
See www.dersoft.com/Mertonmodel.xls and www.dersoft.com/Mertonequity.xls

The Merton 1974 Model using equity as proxy
One of the drawbacks of the Merton model is that we need the
which are not easily available in practice
However, using equations
E 0  V0 N(d1 ) - D e -rt N(d 2 )
and
N(d1 )V0 σ V
E0  (from Ito’s lemma)
σE
we can input E and σE and solve for V and σV
See www.dersoft.com/Mertonequity.xls
The Merton 1974 Model – Application
Market leader Moody’s-KMV follows Merton 1974 most closely:
Asset Value V Cumulative

asset return
distribution N
r
DD=d2
Debt D N(-d2)=EDF
time
T
EDF : Expected Default Frequency = real life default probability
V 1
ln( )  σ 2V T
DD: real life Distance to Default  risk-neutral d2 =
 rT
De 2
σV T
Critical appraisal of the Merton 1974 Model
• Ingenious model, which serves as the basis of all structural models
Criticism:
• It is a simple model:
a) Only ONE form of
b) Default only possible at
Simplicity has lead to the “First time passage models”
Empirical testing has overall not given good results (P. Crosbie, “Modeling
Default Risk,” in Credit Derivatives: Trading & Management of Credit and Default Risk; Jones E., S.
Mason and E. Rosenfeld, “Contingent Claim Analysis of Corporate Structures: An Empirical
Investigation,” Journal of Finance, 1984 39(3), p.611-628 and Kamakura, “Comparison of the Merton
and Jarrow Credit Models for Pricing Risky Debt”, Internal Kamakura paper to be received at
www.Kamakuraco.com)
- Reduced Form Models
Jarrow, Turnbull (1995), Jarrow, Lando, Turnbull (1997), Duffie, Singleton (1999),
Hull, White (2000), Kettunen, Ksendzovsky, Meissner (2003)
Reduced Form Models do not investigate company specific data as the capital
structure. That`s why they are called reduced form.
Reduced Form Models model the bankruptcy process within the arbitrage-free,
risk-neutral Martingale framework.
Default as well as interest rates are usually modeled in a binomial model.

-Reduced Form Models; Jarrow Turnbull 1995
For a 2-period economy the default process looks like this:
RR 1
RR  : Default Probability
0
wrong!
B0,2 RR since we assume the notional amount N = 1,
1
the Payoff (e.g. $ 0.2) = RR (20%) x $1
1-0
1-1 B0,2 : Risky Bond price at time 0 with maturity
2
1
time 0 1 2
For a 2-period economy the Treasury bond price tree maturing at t2
and risk-free interest rates tree looks like this:
t1 t2
BuTr r1u
0 1 0 : Probability of r1u occurring
1-0 : Probability of r1d occurring

B0 Tr r0
BTr : Treasury Bond price
1-0 r1d Note that B0Tr, BuTr BdTr are given, since
1
B Tr all rates r are given due to the underlying
d
term structure model
Note that since interest rates are time period variables, we don`t need 1 and 1-1 because
at t1, we know that the interest rate from t1 to t2 will be either r 1u or r1d
Combining the previous 2 trees, we get the risky Bond price tree
for a 2-period economy and the bond maturing at t2:
B1,2,a= RR 1
0 0 RR(1+r1u)  : Default Probability of risky bond B
1 0 : Probability of r increasing (of r1u occurring

0(1- 0) B1,2,b= RR RR(1+r1d)
B0,2 RR : Payoff in Default or Recovery Rate
(1-0)0
1 RR Bt : Risky Bond price
B1,2,c
1-1
1 1
(1-0)(1- 0 )
B1,2,d 1-1
We know B0. RR is assumed exogenously. So how can we find 0, 0 and 1???
0 can be found from the risk-free interest rate tree:
t1 t2
BuTr r1u Recall that all r`s are given due to the term structure model
0 1
BuTr = 1 / e r1u t BdTr = 1 / e r1d t
B0Tr r0
B0Tr is a spot price, so given
1-0 r1d
1
B d
Tr
Discounting back from t1 to t0, what is B0Tr ???
B0Tr = [ 0 Bu + (1- 0 ) Bd ] / e
Tr Tr r t 0
Solving for 0 we get
0 =
0 = (BdTr - B0Tr e r 0
t
) / (BdTr - BuTr )
Example: The term structure model results in r1u = 6% and r1d = 5%.
r0 = 5.3%. Assuming t =1 and B0Tr = 0.9, what are 0 and 1- 0 ?
BuTr = 1 / e r1u t
BdTr = 1 / e r1d t
Therefore
0 =
and 1 - 0 =
Next, lets find the value of .
B1,2,a= RR 1 From our 2-period risky bond price cash flow tree
0 0 RR(1+r1u) we know that B3 and B4 have not defaulted
1 Therefore, we can derive the price of B3 and B4 from

0(1- 0) B1,2,b= RR RR(1+r1d) the risk-less interest rate tree. So B3 and B4 are given.
B0,2
(1-0)0 Discounting the probability weighted values of t2:
1 RR
B1,2,c RR and 1 back to t1, we get
1-1
1
(1-0)(1- 0 ) 1 B1,2,c = [1 RR + (1- 1 )] / e r 1u t
1-1
B1,2,d B1,2,d = [1 RR + (1- 1 )] / e r 1d
t
Solving these 2 equations for 1 , we get

1 = and 1 =
(From these 2 equations it follows that B1,2,c e r t = B1,2,d e r t )

1u 1d
B1,2,c and B1,2,d are forward bond prices from t1 to t2. They can be deducted from the market.
Let’s derive 0 and 1 from a simple binomial tree.
Deriving the risk-neutral default probabilities 0 and 1
0 can be derived from a risky 1-year maturity bond B and a risk-free rate r 0
For a 1-year risky bond we have:
RR
0
B0
1-0
1
From this figure we get
(1) B0 =
Solving 0 for we get

Deriving the risk-neutral default probabilities 0 and 1 cont
RR
0
B0, T=2 RR
1
1-0
1-1
1
From the above figure, we get:
B0, T=2 =
Solving for 1we get

Deriving the risk-neutral default probabilities 0 and 1 cont
Example: The risky 2-year maturity bond has a price B 0,T=2 of 0.85, the risk-free 1-
year and 2-year spot interest rate r0,T=1 =5% and r0,T=2 = 5.5%, the recovery rate
RR is 40% and (from the previous example) 0 is 3.72%.
What is the probability of default at the end of year two, 1?
1 =
(See www.dersoft.com/jt.xls)
Critical Appraisal of the Jarrow Turnbull 1995 model
The Jarrow-Turnbull 1995 model was one of the first reduced form models that incorporated
credit risk in the pricing algorithms of derivatives in a no-arbitrage martingale framework. It
is a path breaking article that serves as a basis for most, more elaborate reduced form models
used in today’s trading practice.
The shortcomings lie in the basic approach of the model: the direct economic reasons for default,
i.e. the company’s specific asset-liability structure or the company’s liquidity are not part of the
analysis. Rather, bond prices are the major input, assuming that bond prices can serve to reflect
the credit risk of the debtor and to derive default probabilities. However, it has been shown that
bond prices overestimate a company’s probability of default quite substantially (see e.g. Altman
1989). In addition, bond prices are often quite illiquid, resulting in difficulties to determine a fair
mid-market price.
Furthermore, it is assumed that the interest rate process and the default process are independent.
Also, the default intensity is assumed constant, thus default is equally likely over the life of the
debt. Last, the recovery rate of the model does not depend on the model variables, but is exogenous.
-Reduced Form Models; Jarrow Lando Turnbull 1997
In their 1995 model, Jarrow and Lando focus on the rather illiquid bond
market to generate default probabilities.
To overcome this shortfall, Jarrow, Lando and Turnbull 1997 use
historical transition probabilities to find default probabilities.
A transition matrix gives the probability of moving from an original credit state
to another credit state within a certain time frame.
There are usually 8 credit states in a transition matrix:
AAA, AA, A, BBB, BB, B, CCC, D

The risky zero-coupon bond B with a PA of 1 and maturity T can be expressed
as the discounted value of a default probability weighted sure dollar:
B = [RR + (1-RR) QT] / erT
where QT is the survival probability until T and
(RR : Recovery rate (exogenous), r : risk-free interest rate, T : maturity of B)
This equation is identical with equation the standard bond price equation,
as for example in the Jarrow Turnbull 1995 model, since Q=
If QT = 1 it follows that B =
If QT = 0 it follows that B =
If QT = 0.5 it follows that B =
QT is derived from the historical transition probabilities as follows

Let’s assume we have only 4 credit states: A, B, C, D where D is default
The probabilities of such a transition matrix are:
Rating at
year end
A B C D
Initial Rating
A
A A A B A C A D
B B A B B B C B D
C
C A C B C C C D
D
D A D B D C D D
Let’s assume our 4 states have the following transition probabilities:
Rating at
year end
A B C
Initial Rating D
A
0.7 0.15 0.1 0.05
B
0.1 0.6 0.2 0.1
C
0.05 0.15 0.65 0.15
D
0.0 0.0 0.0 1
In the Martingale world, besides others assumptions, the following two

assumptions hold:
- Due to the assumed risk-neutrality, the expected return of risk-free asset

and protected risky asset is the same (see equation (2.1))
- The present value of any asset is equal to the default probability

weighted discounted future cash flows
The second property is explicitly used by Jarrow, Lando and Turnbull (1997) and Duffie and
Singleton (1999) (see 2 slides ahead), who derive the risky bond price as
B =
T
(The swap spread s is approximately equal to the probability of default as we will see later in the Duffie
Singleton (1999) model)
Finding risk-neutral default probabilities:

Lets assume given are the following, whereby the number index denotes MATURITY time T
 0.05 
r0, T=1 = rT=1 = r1 = 5%  
Or in matrix form: r =  0.06 
r0,T=2 = rT=2 =r2 = 6%  0.07 
 
r0,T=3 = rT=3 =r3 = 7%
The yield spreads (= DS premium also called DS spreads) are

sA,0,T=1 = sA,1 =0.01
sA,,2 = 0.015, sA,3 = 0.02; sB,1 = 0.02, sB,2 = 0.025, sB,3 = 0.03; sC,1 = 0.03, sC,2 = 0.04, sC,3 = 0.05
or in matrix form:
 0.010   0.020   0.030 

     
sA =  0.015  sB =  0.025  sC =  0.040 
 0.020   0.030   0.050 
     
RR = 40%
From the matrix 3 slides before for a one-year bond in rating class A, there is
70% chance of staying in A, a 15% chance of moving to B, and a 10% chance
of moving to C. In this case the payoff is 1.
There is a 5% chance of default, in which the payoff is RR

If the value of the T-year risky bond in class A, B A,T, is the present value of all
probability weighted cash flows, we get:
A  A  1 
   
1 1 A  B   1 
(1) BA,T = =  C  1 
e ( rT s T ) T e rT T  AA 
 D


 
 RR 
   
Equation (1) will almost never be satisfied in reality!!!

A  A  1 
   
1 1 A  B   1 
(1) BA,T = ( rT  s T ) T = rT T  A  C   1 
e e  A  D   
 RR 
   
Lets show that equation (1) is not satisfied
For T=1, with r1 = 5%, s1 =1% , A A = 0.7, A B = 0.15, A C = 0.1 and A D = 0.05
and RR = 40%, we get:
1
( 0.05 0.01) x1

e

What does this mean???
Therefore, JLT multiply the actual transition probabilities with a risk-premium  and transform
them into to risk-neutral probabilities:
Thus, equation (1)
A  A  1 
   
1 1 A  B   1 
(1) BA,T = ( rT  s T ) T = rT T  A  C   1 
e e  A  D   
 RR 
   
changes to
1  (1  (A  A)T )   1 
(1a) BA,T =
1 1 
 (A  B)T



 1 

=
( rT  s T ) T  
e e rT T 
(A  C)T

 1 
 
 ( A  D )   RR 
 T   
Lets just look at T : From our matrix earlier, for a bond in class A we have:
1  (1  0.7)T 
  For T =1 it follows:
 0.15T 
 0.1T 
 
 0.05 
 T 
For T = 0.5 it follows: For T = 0 it follows:
Note that for all T, the risk-neutral probabilities add up to .

How can we find the risk-neutral probabilities  for each rating class ???
We have to solve equation (1a) for T
If we do, we get:
  e rT  T 
Eq (2)  T  1   ( rT  s T )   /(1  Q T )(1  RR ) (see www.dersoft.com/541.doc)
  e  
We derive 1 with r1 = 0.05, sA,1 = 0.01, sB,1= 0.02, sC,1 = 0.03, QT = 0.95 and RR = 0.4
 A,1 
(See cdbae.xls sheet Ex5.16 and
www.dersoft.com/jlt.xls)
 B ,1 
 C ,1 
To derive the risk-neutral matrix, we multiply the actual matrix
A B C
D
A
0.7 0.15 0.1 0.05
B
0.1 0.6 0.2 0.1
C 1  (1  (A  A)T ) 
 
0.05 0.15 0.65 0.15  ( A  B)  
with A1=0.3317, B1=0.6600, C1=0.9852 and e.g. for A 
T

(A  C) T
D 



0.0 0.0 0.0 1  ( A  D ) T 
A B C
D (See cdbae.xls sheet Ex5.16 and
www.dersoft.com/jlt.xls)
A
B
C
D
A B C
D
A
0.9005 0.0498 0.0332 0.0166
B
0.0660 0.7360 0.1320 0.0660
C
0..0493 0.1479 0.6552 0.1478
ThisDrisk-neutral matrix guarantees that equation 1
0.0 0.0 0.0 1
A  A  1 
   
1 1 A  B   1 
(1) BA,T = ( rT  s T ) T = rT T  A  C   1  is satisfied:
e e  A  D   
 RR 
   
For T=1, with r1 = 5%, s1 =1% , A A = 0.9005, A B = 0.0498, A C = 0.0332 and A D = 0.0166
and RR = 40%, we get:
We have found the risk-neutral transition probs for class A and T=1. Naturally,
equation 1 has to be satisfied for all rating classes and maturities
We will now find the value for the risk-premium for T=2, 2.
Transition matrices are usually published for a 1-year time horizon.
To find 2-year transition probabilities, we can use the probability
equation for independent variables:
P(E  F)  P( E)P(F)
Where: P( E  F) : Probability of occurrence for E AND F
Example: Companies E and F and independent. Company E has a default

probability of 3% and company F of 4% within the next year. What is the
probability that E and F will both default within 1 year?
P(E  F)  P(E)P(F)  0.03x 0.04  0.0012  0.12%

Based on this probability independence equation, we can calculate

the transition probabilities for year 2. Firstly, to find the probability A
 A for year 2, we have include all 1-year probabilities that
influence state A. These are
A  A, A  B, A  C, A  D; B  A, C  A, D  A
If we assume that the time spent in one rating class decreases exponentially
in time and that all transition probabilities are independent, we can
approximate the transition matrix for year 2 by
Squaring transition matrix of period 1

 0.70 0.15 0.10 0.05   0.70 0.15 0.10 0.05   0.5100 0.2100 0.1650 0.1150 
     
 0.10 0.60 0.20 0.10   0.10 0.60 0.20 0.10   0.1400 0.4050 0.2600 0.1950 
 0.05 0.15 0.65 0.15  x  0.05 0.15 0.65 0.15  =  0.0825 0.1950 0.4575 0.2650 
     
 0.00 0.00 0.00 1.00   0.00 0.00 0.00 1.00   0.0000 0.0000 0.0000 1.0000 
  
Using equation (2) with T=2, we get the adjustments for risk-neutrality (=risk-premiums):
  e rT  T 
Eq (2) T  1   ( rT s T )   /(1  Q T )(1  RR )
  e  
With rA2=0.06, sA2=0.015, sB2 = 0.025, sC2= 0.04, QA2=1-0.1150=0.885, QB2=1-0.195=0.805, QC2=1-0.265=0.735 and RR=0.4,
we get
 A, 2 
 B,2 
C ,2 
 0.51 0.21 0.165 0.115 
 
 0.14 0.405 0.26 0.195 
 0.0825 0.195 0.4575 0.265 
 
 0.00 0.00 0.00 1.00 
 
With A2=0.4832, B,2=0.4168, C,2=0.4168 and eg. for A (first row in the above matrix)
1  (1  (A  A)T ) 
 
 (A  B) T 
 (A  C) T 
 
 (A  D) T 
 
we get the transition matrix for T=2:
A B C
D
A
B
C
D
From the transition matrices for T=1 and T=2, we can derive the risk-adjustment for assets in
different classes
For example, for an asset (bond, swap, or loan) in rating class B, the probability of default in one
year is 0.0660 (see earlier slide) and the probability of default in 2 years is 0.0813 (see last slide)
Thus, in order to include default risk, if we lend cash in a 1-year loan to a counterpart in rating
class B, assuming RR = 0.4 and the risk-free interest rate is 5%, we should add to the interest
rate payment on the loan the default premium of
Thus, if we lend cash in a 2-year loan with a counterpart in rating class B, we should add to the
interest rate payment on the loan the default premium of
In this example we are ADDING to the interest payment of the loan, since
In order to price ‘vulnerable derivatives’ i.e. derivatives in which the obligor (seller in an option) can
default, we do a very similar analysis. Let’s look at a vulnerable call:
We can use the cumulative default probability of the call seller, (which is implicitly incorporated in the risky
bond price of the call seller), multiply it with the loss given default (1-RR) and discount back to today.
Deducting this from the non-vulnerable call price Dt,T, we find the vulnerable call price Dt,T,V as
 rt , T T
Dt,T,V = Dt,T – [ e  t ,T ,D (1  RR ])
where λt,T,D is the cumulative risk-neutral default probability of the counterparty from time t to
T and RR is the recovery rate. The term represents  t ,T ,D (1  RR ) the default-probability
weighted loss given default.
Here we are subtracting a factor from the call price, since

Example
Let’s assume the non-vulnerable call price of a call with maturity T=2 was derived as 10.00%. Let’s
further assume that the call seller is currently rated single B and his risk-neutral martingale default
probability within two years is 0.05 (see matrix Λ 02m). The recovery rate is assumed to be 40%. What
is the value of a vulnerable call, if the 2-period risk-free zero interest rate r 02 is 6%?
Following the above equation, the vulnerable call price is
C02V = =
Hence the call price of 10% has reduced to or by = %

Critical Appraisal of the Jarrow Lando Turnbull Model:
In the 1995 Jarrow, Turnbull model, default probabilities and credit derivatives prices were derived on the
basis of rather illiquid bond prices. In their 1997 model, Jarrow, Lando, and Turnbull replaced bond prices as
the main input and apply historical transition probabilities as the basis for their analyses. In today’s practice,
many investment banks and insurance companies apply the 1997 model and its extensions to price and hedge
credit derivatives.
O ne specific shortcom ing of the m odel is that the default probability λ i,D can becom e
bigger than 1. T his is especially the case for longer m aturities T . From equation (5.41) w e
  e rt, T  T  1
derive that η i  1   (r t, T  s t,T )   , w hich reduces to
  e   (1  RR) λ iD
 1  1
λ iD  1  s T  . Fo r this equation to be sm aller than 1, w e require that
 e t, T
 (1  RR) η i
1
 1  η i (RR  1) . T his condition m ay not satisfied for large s, T , η, and R R . (see
es T
t
w w w .dersoft.com /jlt.x ls).
General shortcomings of the model lie again in the fact that the ultimate reason of default, the asset-liability
structure or the liquidity of a company is not part or the analysis. Also, as in the 1995 model, the interest rate
process and the bankruptcy process are assumed independent. Furthermore, the recovery rate RR is
exogenously given.
An important Anomaly
From (historical) cumulative default matrices, we can derive an important anomaly in the credit market
Year 1 2 3 4 5 6 7 8 9 10
Aaa 0 0 0 0.04 0.12 0.21 0.3 0.4 0.52 0.64
Aa 0.02 0.03 0.07 0.16 0.26 0.36 0.46 0.57 0.65 0.73
A 0.02 0.09 0.22 0.36 0.51 0.68 0.86 1.07 1.31 1.56
Baa 0.22 0.61 1.08 1.69 2.25 2.81 3.38 3.94 4.58 5.26
Ba 1.28 3.51 6.09 8.76 11.36 13.74 15.66 17.6 19.46 21.29
B 6.51 14.16 21.03 27.04 32.31 36.73 40.97 44.33 47.17 50.01
Caa 23.83 37.12 47.43 55.05 60.09 65.22 69.26 73.88 76.50 78.54
Table 5.3: Average global cumulative historical default rates with respect to time, numbers in %; Source: Moody’s Investor Service, April 2003
From table 5.3, we can conclude that the yield-spread (to a risk-free bond) of an 5-year A-rated bond should be
about basis points (compare equation 2.1and s ~ λ from Duffie Singleton). However, in the bond market, 5-
year, A-rated bonds have a yield spread of about 200 – 500 basis points, depending on the state of the
economy!!
This means…
An important Anomaly
Risky bond prices (in the market) are too low, when compared to
their historical default rates!!!
How can this be explained??
How can we exploit the anomaly??

Naturally, the nature of the transition matrix also bears problems. Jarrow, Lando and Turnbull
assume that bonds in the same credit class have the same yield spread. This is not necessarily the
case as pointed out by Longstaff and Schwartz (1995). Rather, the rating – yield relationship is
similar within sectors, suggesting to conduct sector analyses, rather than aggregating data
generally among counterparties.
A crucial problem is that ratings are often done infrequently and may not be recent enough to
reflect current counterparty risk. In addition, Standard & Poors currently only rates about
8,000 companies in the US, and only about 1% of all companies worldwide. Nevertheless, the
number of rated companies should increase in the future, allowing a widespread usage of the
model and its extensions.
Critical Appraisal of the Jarrow Lando Turnbull Model:
In the 1995 Jarrow, Turnbull model, default probabilities and credit derivatives prices were derived on the
basis of rather illiquid bond prices. In their 1997 model, Jarrow, Lando, and Turnbull replaced bond prices as
the main input and apply historical transition probabilities as the basis for their analyses. In today’s practice,
many investment banks and insurance companies apply the 1997 model and its extensions to price and hedge
credit derivatives.
O ne specific shortcom ing of the m odel is that the default probability λ i,D can becom e
bigger than 1. T his is especially the case for longer m aturities T . From equation (5.41) w e
  e rt, T  T  1
derive that η i  1   (r t, T  s t,T )   , w hich reduces to
  e   (1  RR) λ iD
 1  1
λ iD  1  s T  . Fo r this equation to be sm aller than 1, w e require that
 e t, T
 (1  RR) η i
1
 1  η i (RR  1) . T his condition m ay not satisfied for large s, T , η, and R R . (see
es T
t
w w w .dersoft.com /jlt.x ls).
General shortcomings of the model lie again in the fact that the ultimate reason of default, the asset-liability
structure or the liquidity of a company is not part or the analysis. Also, as in the 1995 model, the interest rate
process and the bankruptcy process are assumed independent. Furthermore, the recovery rate RR is
exogenously given.
-Reduced Form Models; Duffie Singleton 1999
Within the Martingale framework, Duffie and Singleton find an elegant way to model
default risk. The model can be approximated by
RR
λt,T
Bt,T : risky bond price at t with maturity T, t≤T
Bt,T
t,T : Default Probability from time t to T
1-λt,T RR : Payoff in Default or Recovery Rate

1
time t T
From this figure, we get equation:
e-r(T-t) : discount factor

One of the core findings of Duffie Singleton is that the PV of a claim can be derived by discounting the notional
with the default-adjusted short rate. Hence for our defaultable bond price Bt,T we get:
s : credit spread (excess

Bt,T = e -(r+s) (T-t)
yield of the risky bond)
From these 2 equations, we get
1  e -s (T - t)
λ t,T 
(1  RR)
A 4-year BBB-rated bond has a credit spread (i.e. a yield above the 4-year risk-free bond yield) of 80 basis
points. From previously defaulted bonds in the same sector with the same seniority, we anticipate a recovery
rate of 25%. What is the probability of default of the bond during the next 4 years?
An approximation of
1  e -s (T - t)
λ t,T 
(1  RR)
results in the credit triangle
s : credit spread (excess
s yield of the risky bond)
λ
(1  RR)  : Default Probability
Hence for RR = 0
Following equation (2.1), s is also approximately the
annual default swap premium

For continuous time, we get
T
  h(u)du
λ t,T  1  e t
where h is the hazard rate, i.e. the default probability for an infinitesimally short
period of time u conditional on no default before t. The reader will find this
equation in many reduced form model publications.
Homework: Read article “Recent Developments in Default Probability

Derivation” at www.dersoft.com/recentdevelpments.doc and give feedback.
The risk-adjusted rate R = s + r is now modeled on a standard term structure model

as CIR or HJM. The goal is to calibrate the coefficients of the term structure
model, as well as the hazard rate h (which is the default probability of a very short
time frame) and the payoff in default L= (1-RR), so that the term structure fits
defaultable bond prices in trading practice. (Duffie Singleton 1999, p. 26f)
Duffie Singleton suggest a 3 factor HJM model. Due to the rather high number of
coefficients that need to be calibrated, the model has a quite large degree of
freedom for the coefficients.
One key difference between the Jarrow Turnbull model and Duffie Singleton is that
in the Jarrow Turnbull model the payoff in default is the RR multiplied by the risk-
free bond. In the Duffie Singleton model the payoff in default is –more realistically-
the RR multiplied by the pre-default value of the risky asset (termed RMV:
recovery market value) (Duffie Singleton 1999, p. 26f)
Extensions of the Duffie Singleton model:
As in most reduced form models λ and L are exogenous. This assumption can be relaxed, see
Lando (1998), however at the cost of higher complexity (see also Duffie and Singleton 1999, p.
17f, 20)
A further extension is the integration of illiquidity of bonds. In that case the default adjusted
short rate R can be altered, by including liquidity effects l. In this case
R = r + λ (1-RR) + l; l0
which leads to a lower bond price, reflecting the low liquidity
Another extension by Schoenbucher (1997) includes information not only before but at default T.
This is realistic in the sense, that at default T, new information about the defaulting company may
occur. Thus, a possible jump in the asset value at default is incorporated in the model.
Critical Appraisal of the Duffie Singleton Model:
Duffie and Singleton show that any risky claim B with a notional amount N, for
different interest rates r and swap spreads s at various times j, and time units of 1,
with maturity t + Γ, can be expressed as
 1
Bt,t+Γ = Et [e
  ( rt  j  s t  j ) Nt+Γ]
j0
Since the Duffie Singleton model is a reduced form model, the before mentioned criticism applies:
The shortcomings lie in the basic approach of the model: the direct economic reasons for default,
i.e. the company’s specific asset-liability structure or the company’s liquidity are not part of the
analysis. Rather, bond prices are the major input, assuming that bond prices can serve to reflect
the credit risk of the debtor and to derive default probabilities. However, it has been shown that
bond prices overestimate a company’s probability of default quite substantially (see e.g. Altman
1989). In addition, bond prices are often quite illiquid, resulting in difficulties to determine a fair
mid-market price.
Furthermore, it is assumed that the interest rate process and the default process are independent.
Also, the default intensity is assumed constant, thus default is equally likely over the life of the
debt. Last, the recovery rate of the model does not depend on the model variables, but is exogenous.
-Reduced Form Models; Hull White 2000
Hull and White 2000, generate an approximate closed form equation to find the value of a default
swaps within the Martingale framework. Their analysis includes accrued interest:
Similar to a bond, a default swap usually requires the payment of accrued interest, when default
occurs. Therefore the payoff in case of cash settlement is:
Payoff = PA – RR x PA – RR x A x PA
where PA : principal amount; RR: recovery rate; s : DS premium pa;

A : accrued interest = time in years from the last coupon payment date to the default date x coupon o
the reference asset (in percent) x PA
Example: The annual coupon of the reference bond is 7%, half of which is paid January 1st and
July 1st each year. The underlying is 10,000 bonds with a par value 100, so the principal amount is
$1,000,000. Default of the bonds occurs on April 1 st. Lets assume that there are 91 days between
April 1st and Jan 1st. A dealer pole determines the value of the bond as $40. What is the payoff of
the DS swap in case of cash-settlement?
$1,000,000 – (0.4 x $1,000,000) – (0.4 x 0.07x91/365 x $1,000,000) = $593,019.18

Hull White find an approximate equation for the annual DS premium:
( y  y Tr )(1  RR  aRR )
s
(1  RR )(1  a Tr )
s : DS premium pa, y: yield of the risky bond, y Tr: yield of the Treasury bond, a: average
accrued interest of risky bond, aTr: average accrued interest of Treasury bond, RR : recovery
rate
Example: The yield of a risky bond is 8%, the yield of the Treasury bond 5%. The recovery
rate is assumed to be 40%. Assuming the bonds trade at par, the coupon equals the yield so
that the average accrued interest of the risky bond a = 4% and the a TR = 2.5%. What is the
DS premium pa?
(0.08  0.05)(1  0.4  0.04x 0.4)

s  2.85%
(1  0.4)(1  0.025)
The equation on the previous slide 180 works quite well if the Treasury
yield curve is flat, interest rates are constant, and the risky and Treasury
bond trade at par. The more these assumptions -especially the par value
assumption- are not given, the more the approximate equation gives
results unequal the true DS value, i.e. the value derived on a term
structure model with non-par values of the both bonds.
Critical Appraisal of Reduced Form Models
- Elegant, intuitive, no-arbitrage risk-neutral framework
- But relies on bond prices as input!
-Some reduced form models add liquidity premium (e.g. Duffie,

Singleton 1999, Duffee 1999), or equity prices (Jarrow 2001)
The Future…
A combination of Structural and Reduced Form models
(as Duffie and Lando (2001)) or Kamakura with their
hybrid Merton-Jarrow model
Complex Swaps
The most actively traded complex swaps are:
Yield curve swaps

Libor in-arrears swaps
Differential swaps
Index amortizing swaps
Volatility swaps
(Book p. 147 - 160)

Yield-curve swaps
Yield curve swaps are floating - floating swaps, a type of
basis swap.
Two interest rates (e.g. the 6ML and the 3y swap rate) are
fixed at certain points in time and exchanged
t0 t0.5 t1 t1.5 t2
3-year 3-year
swap rate swap rate
Why YCS’s? Speculators can exploit shapes and changes

in the yield curve.
Features of the YCS: Popular, fairly easy to price, but
convexity adjustment needed
Book p.147-152)
Libor in-arrears swaps
A LIA is a swap, where the Libor fixing is one period later
than in a plain vanilla swap
t0 F t0.5 F t1 F t1.5 F t2
2-year LIA swap against 6ML

Why LIA’s? Exploitation of yield curve steepness:
If the yield curve is steep, the forward rates and
consequently the value of the expected Libor rates are high.
Therefore, an investor, who believes the yield curve is too
steep and will flatten out, can receive the fixed rate in a YCS.
(Book p.152-156)
Libor in-arrears swaps, cont
7.10% 7% Swap
LIA swap Investor
counterpart Counterpart
6 MLfia 6ML
An investor, exploiting a (presumably) too steep yield curve

receiving fixed in a LIA swap and paying fixed in a plain
vanilla swap (6MLfia : six month Libor fixed in arrears)
The risk, that the investor faces, is that during the course of
the swap, the Libors fixed in arrears will be higher than the
Libor fixings in a plain vanilla swap. This difference 6MLfia -
6ML can overcompensate her 10BP advantage on the fixed
side.
Feature of LIA: Popular, easy to price and hedge
(Book p.152-156)
Differential Swaps
In a Diff-swap two counterparts agree to exchange a series of
cash flows based on indices of different currencies, on the
same principal amount in the same currency:
yen 6ML
on $ 1 million
paid in $
A B
$ 6ML
on $ 1 million
$ 6ML paid in $
$ 1 million
on $ 1 million
paid in $
Loan
provider
Why Diff-swaps: Cost-Reduction, without currency risk!

Features of Diff-swaps: Popular, fairly difficult to value and hedge
(Book p.156-159)
Index Principal Swaps = Index Amortizing Swaps
In an IPS, the principal amount decreases, if an index, usually
the Libor, hits a certain level:
6ML at t0 and a Amortization

spread of
-200 Bp 100%
-100 Bp 50%
-50 Bp 25%
0 Bp 10%
+50 Bp 0
(Book p.156-159)
Index Principal Swaps cont
6 ML
A B
(Buyer) (Seller)
fixed rate, above par
The amortizing feature has a positive value for B:
If the 6ML decreases, the increasing negative cash flows of the

swap for B will be small, because the swap amortizes.
If the 6ML rises, the cash flows of the swap increases for B. It
does not decrease because of the absence of amortization.
(Book p.161)
Index Principal Swaps cont
Why IPS’s?
IPS’s are popular in the USA, because they are used to
hedge Mortgage Backed Securities with a redemption feature:
6 ML
A B
(Buyer) (Seller)
fixed rate, above par
mortgage mortgage
amount rate
Morgagee
The buyer A reduces his mortgage payment cost and is left paying 6ML.
This is not very risky because the swap amortizes if the 6ML increases.
An IPS has an option feature and is usually price on
Pricing IPS is difficult. term-structure based models. The buyer of the IPS
is actually the option seller!
(Book p.161)
Volatility Swaps/Variance swaps
Definition:
A volatility swap is a swap in which one counterpart
pays a fixed volatility rate, the other counterpart pays
a floating volatility rate.
A variance swap is simply a swap in which the volatility

is squared.
The Volatility is the standard deviation of logarithmic

price differences
1 n _
1 n
Vol ( S )  
n  1 i 1
(ln( S i / S i 1 )  S *) 2
 
n  1 i 1
(ln( S i / S i 1 ) 2
Volatility Swaps/Variance swaps, cont
To pay-off off a volatility swap is:
NPA (realized Vol – K Vol)
So if the NPA is 100,000, the realized vol is 25 percent

and the strike vol 20 percent, the payoff is
100,000 * (25 – 20) = $500,000
To pay-off off a variance swap is:
NPA (realized Vol2 – K Vol2)

100,000 * (252 – 202) = $22,500,000
Floating Vol
A B
Seller Buyer
Fixed Vol, e.g., 20%
The terminology that the seller receives a fixed volatility

is opposite to the usual swap terminology.
The underlying instruments of a volatility swap

can be any financing instrument.
Why a volatility swaps?
A volatility swap guarantees an investor pure volatility

exposure.
Volatility swaps are mainly used for hedging:
Floating volatility can be received, to hedge against

a short straddle position
A company wants to issue a convertible bond. If the
vol of the stock decreases, the option feature will
decrease in value and the company has to pay a higher
coupon. To hedge against this decreasing vol exposure,
the company can receive fixed in a vol swap:
Floating Vol
Swap
Issuer
counterpart
Fixed Vol, e.g., 20%
Floating
Vol
Bond
Naturally, swaps can be used for speculation

Pricing:

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Syllabus Advanced Derivatives

Course: Fin3610/6610: Exploring New Boundaries in Derivatives

Professor: Dr. Gunter Meissner

Literature: 1) Trading Financial Derivatives, Gunter Meissner

Grading: Attendance and Participation 10%

Lecture 1: The Mathematical foundation of Derivatives Pricing (Generalized Wiener

Lecture 2: Black-Scholes revisited: Assumptions, Concept, Criticism (Distribution,

Lecture 3: Standard exotic Options (Digitals, Barriers, Lookbacks, Average options)

Lecture 4: Standard exotic Options continued (Compound options, Choosers,

Lecture 8: Introduction to Credit Derivatives (The Market, the Products, Relationship

Lecture 9: The Application of Credit Derivatives (Hedging, Speculation,

Lecture 10: Synthetic Structures (CLNs, CDOs (Cash, Synthetic), TPDS,

Lecture 11: Quantifying Credit Risk (Jarrow-Turnbull 1995, Jarrow-Lando-

Lecture 12: Quantifying Credit Risk cont. (Duffie-Singleton 1999, Hull-White

Lecture 15: Final

6) New developments in the Risk-Management

42) The CDO market – Status quo of a crash, Outlook

43) Implementing Gaussian quadrature to value CDOs

48) Rewriting Robert Engle’s (with Arthur Berd and Artem

49) Modeling non-normal CDO returns – The Omega Function

•Risk Management (fast growing area); Fin3801/6801

•Product Developer (well paid)

•Broker (Private Investor, Interbank)

It is typically assumed that the underlying instrument follows a

In a a variable (stock) grows with

dS : change in the stock price S

The discrete version is

Thus, the stock price after one day is assumed to be

What determines the ‘width’ of the distribution???

(See Excel sheet TRADE SMART/Options/Geometric Brownian Motion.xls)

The geometric Brownian motion can be easily programmed in Excel. We

to find epsilon. R is a random number between 0 and 1 (Rand() in Excel)

Critical appraisal of the geometric Brownian

• Captures the property of uncertainty

• Are stock price movements totally uncertain??

What about business cycles?

• Are the price movements of other commodities as

Is a stock price a martingale?

Is a zero-coupon bond a martingale?

Risk-neutrality implies that:

Are investors risk-neutral???

• Lower liquidity of bond prices

where  is the Sharpe ratio, often referred to as the

It is (15% - 5%) / 20% = 0.5

One equation that satisfies the PDE

is the famous Black-Scholes equation. For a call:

Homework: Prove this for a put!

Exotic options are options, whose payoff, valuation and

(Book page 305)

q : continuously compounded, known return of the underlying asset

(Book page 235)

A digital option is an option, which pays a fixed amount of

Digital options are also called binary or bet options.

There are two types of digital options:

A cash or nothing put, or cash or nothing bear digital has a

The price function looks like the delta of a standard call!

The maximum of the delta is??

(Book p.307, 308)

Features of the gamma are:

(Book p.307, 308)

The pricing of cash or nothing digitals is straightforward.

A digital put has a price of