TABLE OF CONTENTS Unlike the basic forms of the contracts discussed in Chapters 4 through 8, basket default swaps are credit derivatives written on a basket or portfolio of assets issued by more than one reference entity. In particular, a payment by the protection seller in a basket swap can be triggered by a default of any one of the entities represented in the basket, provided that default meets the requirements specified in the contract.
We briefly encountered a common variety of a basket default swap the first-to-default basket in Chapter 1 when we introduced different types of credit derivatives. We will now take a closer look at this instrument, this time to illustrate the basic structure of basket default swaps. We also use this chapter to highlight the importance of default correlation in the pricing of multi-name credit derivatives, an issue we will examine in greater detail in Part IV of this book.
Let us look at a particular example. Consider an institution that wants to hedge its exposure to five different reference entities. The institution enters into a first-to-default (FTD) basket contract with a derivatives dealer where the reference basket is composed of those five entities. The institution, which is the protection buyer in the contract, agrees to make periodic premium payments to the dealer (the protection seller), much like in a single-name credit default swap. In return, the dealer commits to making a payment to the institution (the protection buyer) if and when any one of...
