Portfolio default swaps are similar to basket swaps (Chapter 9) in that they transfer portions of the credit risk associated with a portfolio from a protection buyer to a protection seller. A key difference is that the risk transfer is specified in relation to the size of the default-related loss in the reference portfolio instead of in terms of the number of individual defaults among the reference entities. For instance, whereas protection sellers in a first-to-default basket are exposed to the first default in the reference basket, protection sellers in a first-loss portfolio default swap are exposed to default-related losses that amount up to a prespecified share of the reference portfolio.

In Chapter 9 we introduced some key ideas about the role of default correlation in the pricing of multi-name credit derivatives. We continue to highlight this role here and introduce another key concept for valuing derivatives that reference more than one entity: the loss distribution function. Lastly, by discussing the basics of portfolio default swaps, this chapter lays some of the groundwork for discussing synthetic collateralized debt obligations (CDOs), which are the subject of Chapter 14.