Ronnie Sircar (Princeton University)

The market in credit-linked derivative products has grown astonishingly, from $631.5 billion global volume in the first half of 2001 to above $12 trillion through the first half of 2005. They now account for approximately 10% of the total OTC derivatives market. Despite the popularity and ever-increasing complexity of credit risk structured products, the quantitative technology for their valuation (and hedging) has lagged behind. A major limitation of many approaches is the inability to capture and explain high premiums observed in credit derivatives markets for unlikely events, for example the spreads quoted for senior tranches of CDOs written on investment grade firms. When significant yields are offered for protection against the default of 15-30% of US investment grade firms over the next five years, in some sense the ''end of the world as we know it'', we argue that market participants' risk aversion is playing a large role, and we develop the mechanism of utility-indifference valuation for credit derivatives to quantify this.