Credit Derivatives and Counterparty Credit Risk

Credit derivatives are over‐txhe‐counter (OTC) financial contracts that allow the transfer of credit risk from one market participant to another. Prior to introducing the application of simulation to credit risk, this chapter begins with Merton model, which models firm value and default at debt payment time. This model is then extended to incorporate the widely used Vasicek single‐factor model to measure the risk of a credit portfolio and to price collateralized debt obligations (CDOs). The chapter then investigates the effect of a Gaussian copula and t‐copula on tail dependence, which is crucial to the modeling of default events, and then prices an nth‐to‐default basket default swap. An important application of credit risk models in the wake of the subprime mortgage crisis is in calculating the credit value adjustment (CVA) of counterparty risk in the OTC market.