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Credit Derivatives. Prepared by the Derivatives Working Party of the Faculty and Institute of Actuaries

Published online by Cambridge University Press:  10 June 2011

M. J. Muir ,
A. Chase ,
P. S. Coleman ,
P. Cooper ,
G. S. Finkelstein ,
P. Fulcher ,
C. Harvey ,
F. R. Pereira ,
A. Shamash  and
T. J. D. Wilkins
M. J. Muir
Affiliation:
Watson House, London Road, Reigate, Surrey RH2 9PQ, U.K. Tel: +44(0)1737 274 128; Email: martin.muir@watson.wyatt.com
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Abstract

This paper was written by the Derivatives Working Party, a permanent working party of the Life Research Committee of the Institute and Faculty of Actuaries. Our aim is to consider how life assurers may use, or may wish to use, derivatives, and if their use is unduly constrained, e.g. by regulation. This paper focuses on credit derivatives. We provide an overview of the credit derivatives market, and the strong growth in this market over recent years. We then focus on the two main traded credit derivative instruments — Credit Default Swaps (CDSs) and Collateralised Debt Obligations (CDOs). We explain how these instruments work and are priced, and clarify some of the more complex topics involved, such as the settlement of CDSs, basis risk and the relevance of implied correlation in pricing CDOs. We then consider how life insurers could make use of credit derivatives, for example to provide more efficient investment management in taking exposure to credit risk, or to hedge credit exposures, and consider the regulatory implications of so doing. Finally, in the Appendix, we discuss the credit spread puzzle, and the existence or otherwise of a liquidity premium in corporate bond spreads, with implications for the valuation of illiquid liabilities.

Keywords

Credit DerivativesCredit Default Swaps (CDSs)Collateralised Debt Obligations (CDOs)ISDACredit EventDefaultSettlementCheapest-to-DeliverBasisTrancheLeverageCorrelationAdmissibilityEfficient Portfolio ManagementCredit Spreadz-SpreadLiquidity PremiumCredit Risk PremiumDerivatives for Life Insurers
Type
Sessional meetings: papers and abstracts of discussions
Information
British Actuarial Journal , Volume 13 , Issue 2 , 01 July 2007 , pp. 185 - 236
Copyright
Copyright © Institute and Faculty of Actuaries 2007

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