Valuation and risk analysis of synthetic collateralised debt obligations: a copula function approach

David X Li and Jure Skarabot

This article was first published as a chapter in Credit Derivatives, by Risk Books.

INTRODUCTION

Development of credit derivatives markets

The need to efficiently manage credit risk generated a strong foundation for the expansion of suitable market instruments. Serving this purpose, credit derivatives products are one of the most effective solutions, providing various methods for transfer of credit risk between the market participants. Credit derivatives markets have been through a rapid growth over the last several years. New findings and improvements in credit risk modelling have fuelled the widespread use of credit derivative products. These not only provide the method for credit risk management, but they also allow for alternative investment opportunities and deliver a range of new investment products tailored to their specific requirements to investors.

The main goal of credit derivatives is to transfer reference credit risk between the buyers and sellers of credit protection. Originally, investors were focused on the credit risk associated with the individual names, but today the portfolio risk transfers are more and more prevalent. It became evident that the credit risk