The Art of Credit Derivatives: Demystifying the Black Swan

7

Collateralized Debt Obligations

It wasn’t raining when Noah built the ark.

Warren Buffet

7.1 INTRODUCTION

In this chapter we start with the analysis of multiname credit derivatives. In those contracts the payoff is contingent on the credit events in a portfolio of reference entities. Typical examples are collateralized debt obligations (CDO), first loss on a basket, and first or nth to default swaps.

In a first to default swap the protection buyer pays a fee in return for a lump payment by the protection seller for the first entity to default in the portfolio. The instrument offers cheaper protection than buying individual protection. Consider, for instance, an investor who wants to hedge the credit exposure on a portfolio of five bonds. She feels that for her investment horizon the risk on more than one default is rather small, and instead of buying protection on each single name in the portfolio she chooses to buy protection against one default. In a first loss basket the protection buyer pays a fee to receive protection up to a certain amount on a certain portfolio. Instead of buying protection on the number of entities to default this derivative allows the investor to focus directly on the possible amount lost. As a consequence, the losses in the portfolio may be reduced, improving its rating and ultimately the cost of regulatory capital. Here we see again how the cost of regulatory capital became an important point for decision-making purposes and the development of ...