Nth to default swaps and notes: all about default correlation

Douglas Lucas and Alberto Thomas

An nth to default swap is a credit default swap (CDS) that references a basket of underlying credits, typically three to five names. The protection seller under the swap is exposed to the default of the reference credit that defaults “nth” (first, second, third …). An nth to default note is a creditlinked note (CLN) that embeds this type of default swap in its terms. The purchaser of the note is the seller of credit protection in the embedded default swap. In this chapter, we delve into nth to default swaps and notes, define their characteristics and compare their risks with other derivative and funded instruments.

More than other financial instruments, nth to default swaps and notes are plays on default correlation. Simply put, default correlation measures whether credit-risky assets are more likely to default together or separately. For example, default correlation answers the following question: does a 10% probability of default mean that one out of 10 credits is going to default, or that, 10% of the time, all 10 credits are going to default? If the answer is “in between”, where in between?

Default correlation is essential to understanding the risk of nth to default swaps and

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