Synthetic securitisation and structured portfolio credit derivatives

By Paul Hawkins

INTRODUCTION

The single name, credit default swap (CDS) market trades expected loss (EL), is well-established and is increasingly liquid and standardised. The market for small basket transactions, referencing multiple entities, is growing and diverse. With first, second and nth to default structures, products exist to trade and transfer correlation risk.

Pricing and trading portfolio credit risk is a more complex undertaking. Transactions are individually tailored with a large choice of structural, portfolio and tranching alternatives. Portfolio transactions trade complex correlation and loss combinations.

While single name CDSs pay in the event of credit losses from a single reference entity, small baskets and large portfolios reference multiple entities. The payoff, often called the cash settlement amount, is determined by a formula. The cash settlement amount may include all losses from any reference entity, or it may be defined as losses from the first or second entity to default. In large portfolios it is more common to calculate cash settlement amounts on a tranche, that is, losses between some subordination threshold and some upper band (sometimes called attachment and de

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