Topic · Derivatives & Volatility
← All topicsRates & Credit Derivatives
29 articles · 5 checkpoints · 20 deeper reads · 4 reference notes
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A credit default swap is insurance on a bond or a borrower: the buyer pays a regular premium, and the seller pays out if the borrower defaults, and the fair premium is set by exactly balancing what's paid in against what's expected to be paid out.
The textbook price of a derivative assumes both sides always pay in full. CVA is the discount you subtract because your counterparty might not be around to pay you.
The interest rate you should use to discount a cash flow depends on what you'd actually earn holding the collateral behind it, and for a fully collateralized derivative, that's the overnight rate, not the rate banks charge each other unsecured.
A short rate model treats the interest rate itself as a random, mean-reverting process, like a thermostat with noise, and Vasicek and CIR are the two simplest versions, differing only in whether the noise is allowed to push the rate below zero.
A swaption is the right, but not the obligation, to enter an interest rate swap at a fixed rate on a future date, a rate lock with an opt-out, priced the same way an equity option is, just on a swap rate instead of a stock price.
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