Journal of Risk

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A simple probabilistic approach to the pricing of credit default swap covenants

Etienne de Malherbe

ABSTRACT

In its original credit derivatives definitions, the International Swaps and Derivatives Association set out six credit events that can trigger payment on a default swap and many other obligation and settlement clauses that potentially affect the value of a credit default swap. Market participants have since attempted to reduce the list of events that could trigger payouts by eliminating so-called “soft” credit events. Such events are indeed more akin to credit deterioration than default. In many instances, financial institutions are now left with mismatching contract clauses leading to potential “basis risks” in their books (contracts traded before and after changes in market practices but also contracts containing deliberate changes to standard clauses). The purpose of this analysis is to provide a few simple rules for calculating more precisely the impact of the different contract provisions on the price of a default swap.

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