Basket Credit Derivatives and CDOs

Structured finance has been mostly synonymous with basket credit products that mainly originated from the securitization business. Setting up a securitization factor requires the selection of the kind of risk factor to be transferred; the distribution of this risk; and the allocation of risk to different categories of investors. The most straightforward approach to pricing basket credit derivatives and CDOs (collateralized debt obligation) is by Monte Carlo simulation. Once the proper copula function has been estimated and tested, the Monte Carlo model may be simulated to recover samples of correlated default times. To keep the approach at the most general level, one may describe the procedure. This chapter describes multivariate credit-linked products, which represent the bulk of the structured finance market.