An Overview of Credit Derivatives

Credit risk is the distribution of financial loss due to a broken financial agreement, for example failure to pay interest or principal on a loan or bond. It pervades virtually all financial transactions, and therefore plays a significant role in financial markets. A credit derivative is a security that allows investors to transfer credit risk to other investors who are willing to take it. By facilitating the allocation of risk, these instruments have an important economic function. Yet they have hit the headlines recently. This paper gives an overview of credit derivatives. It discusses the mechanics of standard contracts, describes their application, and outlines the mathematical challenges associated with their analysis. ∗Stanford University, Department of Management Science & Engineering, Stanford, CA 943054026, USA, Phone (650) 723 9265, Fax (650) 723 1614, email: [email protected], web: www.stanford.edu/∼giesecke. †I am grateful to Xiaowei Ding, Baeho Kim and Jack Kim for research assistance, Eymen Errais for providing market data, Alexander Schied for comments, and particularly Stefan Weber for stimulating discussions, comments and suggestions. I am also grateful for the suggestions of an anonymous referee.