| In this document, we start with an overview of the fixed income and foreign exchange markets. The fundamental derivatives concepts, such as the swap curve and mark-to-market, are introduced. We study the credit risk associated with derivative transactions, as resulting from possible counterparty default. Our credit model assumes liquid trading of default-free and counterparty bonds of all relevant maturities. In contrast to the Jarrow-Turnbull model characterized by the exponential distribution of default time, we use the risky bond prices observed in the marketplace as a starting point and imply the distribution of default time. Using this model, we price the credit risk associated with a variety of standard fixed income and currency derivatives. Most importantly, we find a hedging portfolio that utilizes dynamic trading of default-free instruments and counterparty bonds to neutralize the credit risk of any derivative transaction. A few specific examples of transactions that can be an asset to either party, such as interest rate and currency swaps, are explored in the last chapter. |
