Abstract

Credit risk derivatives and securitization techniques are difficult topics to teach. Most students have preconceived ideas about them. Some of them are quite wrong. And frequently many students feel that there is almost something like “black magic” behind the concept that one can create Aaa-securities out of risky assets. Additionally, the fact that credit derivatives played an important role in the recent financial crisis, coupled with the sturdy popularity of certain securitization vehicles, makes a strong case for teaching at least the basics of these topics to undergraduates majoring in economics, finance, or engineering. In this paper, we introduce the basic ideas with the aid of a simple but realistic example, and we illustrate some of the analyses that a prudent investor should carry out when considering such transactions. Finally, we also introduce the correlated binomial, an analytical approach useful to analyze credit risk portfolios.