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More commonly, it will involve physical delivery of the defaulted asset in return for a payment of the par amount in cash. First-to-default baskets have grown in popularity over the past few years. As we shall see, they enable investors to leverage their credit risk and earn a higher yield while being exposed to well-known, good-quality names. In return for protection against the first-to-default, the protection buyer pays a basket spread to the protection seller as a set of regular accruing cash flows.

1 Description A collateralized debt obligation (CDO) is a structure of fixed income securities whose cash flows are linked to the incidence of default in a pool of debt instruments.

The principal protected structure is a funded credit derivative similar to a credit linked note. In a 100% principal protected note with an embedded default swap, the coupon of the note teminates following a credit event. The note then redeems at par on its maturity date. In Figure 23, we show a 5-year principal protected note linked to the default of a reference credit. The note pays a spread of 50 bp over LIBOR. If a credit event occurs before the maturity of the note, some or part of all further coupons terminate, and the investors wait until maturity to receive the full redemption.

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Credit Derivatives Explained by Lehman Brothers.


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