Credit Derivatives & Securitization

Two of the most important — and most infamous — machines in modern finance both do the same deep thing: they move default risk from the people who don’t want it to the people who’ll hold it for a price. A credit default swap (CDS) lets you buy or sell insurance on a borrower’s default without ever touching their bonds. Securitization pools thousands of loans into a single vehicle and slices the cash flows into bonds of wildly different risk — most of them, somehow, rated AAA. Put the two together and you get the credit-derivatives complex that underpins trillions of dollars of risk transfer — and that, in 2008, very nearly took the financial system down with it.

This is an expert capstone of the fixed-income and derivatives tracks. You already know how to price a bond, decompose a credit spread into default and recovery, and build a swap out of two legs. Here you put all of it to work on the instruments a real credit desk, a structured-products group, and a CLO manager actually trade:

• What a CDS is — the premium leg, the protection leg, why only a default triggers a payout, the ISDA credit events, and how the “Big Bang” standardized the whole market into fixed coupons and auctions.
• Spreads & hazard rates — turn a CDS spread into a probability of default with the credit triangle ($\text{spread} \approx \lambda(1-R)$), build a survival curve, and mark a CDS to market with its risky annuity.
• CDS indices — how CDX and iTraxx bundle 100–125 names into one tradable spread, the six-month roll, and the basis between the index and the names inside it.
• Securitization — pool loans into a bankruptcy-remote SPV, issue bonds against them, and meet the MBS and ABS that result, prepayment risk and all.
• Tranching & waterfalls — slice the pool by attachment/detachment points, pay the cash out through a waterfall, and see how subordination and other credit enhancement turn mediocre collateral into a fat AAA tranche.
• Correlation & 2008 — the one variable that prices every tranche, the Gaussian copula that modelled it, and the precise way mis-estimating it vaporized “safe” senior tranches, AIG, and the monolines.
• CLOs today — the modern, actively managed cousin built from leveraged loans, the OC/IC coverage tests that force-deleverage it in a downturn, and why its AAA notes have essentially never lost a dollar.

By the end you’ll build a CDS leg by leg and price it from a hazard curve, read an index and its basis, run a pool of loans through an SPV and a waterfall, explain to a sceptic exactly how correlation broke the senior tranches in 2008, and tell the difference between the structure that blew up and the one that didn’t — the working toolkit of a credit-derivatives trader, a structurer, and a securitized-products investor.