Basket Default Swaps（487-503）.pdfVIP

22 Basket Default Swaps* Key words: credit derivatives, defaultable bonds, simulation 22.1 Problem Statement Credit derivatives are financial contracts allowing the transfer of credit risk from one market participant to another. This feature improves the efficient allocation of credit risk amongst market participants. For this reason, in recent years credit derivatives have become the main tool for transferring and hedging risk. Credit derivative markets have rapidly grown in volume and variety of traded products. Credit-linked securities have experienced various applications, ranging from hedging default risk, to freeing up credit lines, to reducing regulator capital requirements, to hedging dynamic credit exposure driven by market variables and to diversifying financial portfolios by gaining access to otherwise unavailable credits. The outstanding balance of credit derivatives contracts has increased from an esti- mated USD 50 billion in 1996 to almost USD 500 billion at the end of the year 2000. According to the 2003 ISDA survey the volume of the credit derivatives market has reached an outstanding notional of more than USD 2 trillion in February 2003. The exact size of the global credit derivatives markets, however, is difficult to estimate, given the potential for overcounting when contracts involve more than one coun- terpart. Moreover, the notional amounts outstanding considerably overstate the net exposure associated with those contracts. Credit default swaps (CDS) constitute the fundamental class of credit derivatives (Schonbucher (2003)). These instruments allow banks to hedge credit risk underly- ing loans and other interest rate positions. A more complicated credit-linked product is the basket default swap (BDS), whose pay-off is contingent on the default occur- ring within a basket of bonds. More precisely, a basket default swap is a bilateral contract whereby one counterpart, named the “protection seller”,