Introduction and Pricing under Counterparty Risk

Abstract

This chapter starts the credit part of the book. In this first chapter we are going to introduce the financial payoffs and the families of rates we are dealing with in the following. But before doing so, we present a guided tour to give some orientation and general feeling for this credit part of the book. The guided tour is given in Section 21.1. Then we introduce as first credit payoffs the prototypical defaultable bonds in Section 21.2. Credit Default Swaps (CDS) payoffs and defaultable floaters, including a relationship between the two, are presented in Section 21.3. In particular, in Section 21.3.5 we explain that CDS’ allow in principle to strip default or survival probabilities in a model independent way, and in Section 21.3.7 we consider some different definitions of CDS forward rates, with analogies with earlier parts of the book, and with LIBOR vs swap rates in particular. In Section 21.3.8 instead we explore in detail possible equivalence between CDS payoffs and rates and defaultable floaters payoffs and rates. We anticipate some facts on intensity models that will be clarified completely later on in Chapter 22, where we also present more detailed results on CDS calibration.