Credit risk is probably one of the most significant risk classes for financial institutions. Until recently, and unlike market risk, there has not been a well-developed and liquid market in pure credit risk. Moreover, institutions have typically concentrated on reducing their net market risk exposure at the expense of incurring increased credit risk. Credit Derivatives, however, allow institutions to change their exposure to a range of credit related risks. Default swap, total return swap and credit linked notes are the most significant credit derivative instruments.
This paper summarizes the structures of credit derivatives and provides valuation methods. Valuing credit derivatives is very difficult and risky, because the default history will not tell the future default events accurately and default processes are not known exactly. Although the historical default data from international rating companies like Moody's and S&P are not perfect, they can be applied to valuing default swap. Default swap premiums which are calculated by swap pricing formula are illustrated in the contents.
Benefits from credit derivatives can be offset by the risks they contain. Basis risk, correlation risk, liquidity risk, pricing risk and counterparty risk are major credit derivatives risks. Institutions who enter into credit derivatives contracts should develop their well defined internal systems to control these risks.
