An investigation into the mechanics and pricing of credit derivatives

With the exception of holders of default-free instruments, a key risk run by investorsis credit risk. To meet the need of investors to hedge this risk, the market uses creditderivatives.The South African credit derivatives market is still in its infancy and only the verysimplistic instruments are traded. One of the reasons is due to the technicalsophistication required in pricing these instruments. This dissertation introduces thekey concepts of risk neutral probabilities, arbitrage free pricing, martingales, defaultprobabilities, survival probabilities, hazard rates and forward spreads. Thesemathematical concepts are then used as a building block to develop pricing formulaewhich can be used to infer valuations to the most popular credit derivatives in theSouth African financial markets.