| We assume the unorthodox premise that every financial transaction is born from a disagreement about its value. The focus is on credit derivatives, which involve the transfer of credit risk from one party to another. We discuss the pricing of a credit default swap, first from the risk-neutral perspective of the market maker. Then, turning to the risk/reward perspective of the investor on the other side of the trade, an approach is put forward based on utility functions, which does not require the Gaussian assumption behind Modern Portfolio Theory. We end with a discussion of derivative counterparty risk, and how to price the exotic default swap that hedges it. |
