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Mark-to-market pricing
Guidelines for pricing and risk
managing credit derivatives
Introduction
What are credit derivatives in essence? How to use them?
How liquid are they? How to price them? A lot of question
marks for fairly natural though powerful new products. One
thing is certain: they are used more and more by derivatives
players and their usage is growing dramatically.
Standard derivative contracts exhibit a complex mix of risks
that can be identified by looking at all the parameters that can
influence their value in some way. Those are equity risk,
interest rates risk, credit risk, volatility risk, tax risk etc. For
some of them, the list could be long. A convertible bond, for
example, is a product in which interest rates, equity price and
credit rating of the issuer act together in a non trivial way (in
the sense that they cannot be easily separated) to constitute its
price and its change of value. Credit derivatives, on the
contrary, try to isolate credit risk into one product, or at least
make credit risk the main driving factor. For this very reason,
a fine, consistent and accurate modeling of the default event
and the default probabilities becomes crucial. In the following,
we will try to answer a few questions related to this new
challenge.
The second approach described above can be considered as a
mark-to-market pricing of credit derivatives. The reason why
mark-to-market makes sense in many situations (in the finance
industry in general) is that it reflects the actual cost of hedging
those credit derivatives products and therefore respects the
non-arbitrage condition. Of course, implying default
parameters from a security A to price another security B only
makes sense if A is actually used as a hedge for B, a pre-
requisite that often generates an issue of liquidity on A. We
will only consider this approach in the following.
Along those lines, pricing requires first the identification of
reference instruments on which liquidity is sufficient. Those
would generally be Bonds, FRNs (Floating Rate Notes) or
credit default swaps. A pricing engine, able to compute prices
for those instruments given default probabilities, will allow by
calibration to imply the default probabilities from observed
market prices for reference instruments. The pricing engine
will then be able to generate prices for more complex credit
derivatives product (or credit dependent structures in general)
such as credit default swaps (when the reference instruments
were bonds), total return swaps, credit options One has to
note that for some of those, an history of prices for reference
instruments might be necessary (see issues on credit volatility
later).
Pricing engine
Price of

probabilities
reference CALIBRATION

Default
instruments
Source for default probabilities

Credit risk being by definition the main risk factor when it Price of
comes to credit derivatives, their pricing is down to estimating complex
products
Pricing
the probability of default. This will be achieved differently
depending of the type of player and the level of liquidity
available on various markets, but two main approaches can be
considered:
1) The probability of default results from a prediction or a
personal view. Simple example
This approach is relevant for unhedged investment
decisions and speculative positions. The reasoning behind
could be based on a directional view or could be the Let us consider a 5 year zero coupon bond (p: default
conclusion of the study of the healthiness of a given probability on the period):
corporate for example. Actual market price of default 1-p B 5Y=100 if no default
would only influence the ability to put on the trade given B0
this view.
p
B 5Y=0 if default
2) The probability of default is implied by the market value In this case we have:
of given traded instruments. B0=100*(1-p) i.e. p = 1- B0 / 100
If simple enough credit dependent structures are actively
traded on the market for a particular corporate (or With 5Y interest rates at 5%, we would have:
country), a default probability can usually be implied B0=78*(1-p) i.e. p = 1- B0 / 78
from their prices. This approach is relevant for traders (as 1/(1+0.05)^5 = 0.78 )
managing a whole portfolio of credit risky positions and
envisaging to hedge them. Example: if Bond is quoting 75 today, we get an implied
probability of default of 4.3%

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 NB: recovery value, which should come into the equation,
has been assumed to be 0.
Cumulative probability, density of probability and term
structures
In the previous example, we have seen how a default
probability can be deduced from the bond price. Let us
consider that two bonds on the same corporate are quoting:
- 3 year Zero = 87 (3Y interest rates = 4%)
- 5 year Zero = 75 (5Y interest rates = 5%)
In this case, we would get 2 cumulative default probabilities
(DP):
- DP from now to 3 years = 2.1%
- DP from now to 5 years = 4.3%
A forward probability, representing the probability that the
company defaults between 3Y and 5Y (conditional to its
survival in 3 years), can then be computed:
As we have: DP 5Y = DP3Y + (1-DP 3Y)*DP 3-5Y
Then we have: DP 3-5Y = (DP 5Y - DP 3Y)/ (1-DP 3Y)
In our example: DP3-5Y = 2.2%
These fairly straightforward calculations could be extended to
more maturities. Of course, many more factors will have to be
accounted for in real pricing situations. Those include the
recovery rate, liquidity issues, seniority of the various bonds
used if they differ, coupons, the difficulty lying in the fact
that only one parameter (default here) can be computed from
one price.
The main results at this stage are that:
1) We are dealing with full term structures of
probabilities
2) Two types of probabilities, cumulative and
forward default probabilities, are available to us:
a mathematical formula links them together.
NB: cumulative probabilities will generally be used in
analytical methods, where forward probabilities will be used
in discretised methods such as Monte-Carlo, tree or PDE.
Credit default swaps
A question may arise concerning one of the most popular
category of credit derivatives that credit default swaps (CDS)
are: should they be considered as reference instruments or
complex instruments? The answer depends on the type of
player (will he be hedging them or not) and the liquidity of
various available instruments (will he be able to hedge):
High liquidity on CDS High liquidity on
Bonds/FRNs
User of CDS Reference instruments
and complex to trade and price other
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instruments products
Provider/tra Book running based on Book of CDS
der of CDS active market making hedged with
of the credit curve Bonds/FRNs
Using default probabilities in real life
Although commonly used, the previous methodology and
calculations, which will be called bootstrapping in the
following, can turn out to be too simplistic and restrictive, the
main reason being that they do not specify any dynamics for
the changes of credit situations. Default probabilities are
random and the forward probabilities computed earlier are
only todays expectation of their future value. In effect,
forward probabilities alone are sufficient when a static
hedging strategy can be identified. Also, by restricting pricing
to the use of todays cumulative and forward probabilities, one
would be lead to assume that credit changes independently
from other risk factors. This is an issue in many real life
situations. Let us consider three of them:
1) Counterparty risk.
When a player A buys a credit derivative structure from
another player B on a corporate C, he should not only consider
the default probability intrinsic to the underlying C of the
credit derivative product but also the probability of default of
the counterparty B itself. For instance, a simplistic pricing,
performed by A, of a credit default swap where B pays $1
million to A if C defaults would consist of simply multiplying
four terms:
$1 million * C default probability * B default
probability * discount to payment
It would then appear that our cumulative probabilities are
sufficient for pricing the CDS. However, previous approach
totally ignores the correlation between both events, which
could be important and would impact the valuation. A proper
joint diffusion of the factors is therefore necessary.
2) Credit options
Credit options, like options on bonds or options to enter in an
asset swap, obviously need much more information than just
the current spread curve or default probability curve. The
volatility of change of those spreads or probabilities needs to
be assessed for the pricing to be at least realistic. This
obviously requires a proper modeling of the diffusion of credit
spreads and default probabilities.
3) Impact on stock prices
While credit derivatives concentrate on the credit risk, other
products, have a strong credit component. Taking into account
the credit situation of a corporate C for pricing derivative
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products on its equity price requires a modification of the
dynamics of the stock (while keeping a constant forward) to
integrate the probability of the stock going to zero in case of
default. See graph.

[
E t S t + d t no def ]
1-p
Forward
St

p
0
t t+dt t t+dt

4) Risk Management

We have seen how pricing credit derivatives and credit

dependent structures requires modeling credit spread as a
dynamic process. From a risk management perspective,
especially at a global level, credit measure should be
incorporated consistently in all parts of the business. It is
therefore necessary to measure and incorporate the links and
correlations that exist between credit and other risk factors
such as equity prices, interest rate levels or liquidity factors.

Conclusion

Failure to assess the dynamics of the credit spread, its

relationships with other risk factors and the non-linearities of
those relationships can dangerously lead to mis-pricing credit
derivatives or underestimating the risks of credit dependent
structures in general. In that respect, great benefit can come
from the use of standard derivative pricing techniques in terms
of defining a dynamic process for credit spread, performing a
risk-neutral pricing of credit risky products and ni tegrating
correlation between factors, techniques that can only improve
how realistic and reliable global market and credit risk
measurements are.

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