The aim of this paper is to estimate the fair spread of reconstituted basket credit default swap using Japanese market data. The value of these instruments depends on a number of factors including credit rating of the obligors in the basket, recovery rates, intensity of default, basket size, and the correlation of obligors in the basket. A fundamental part of the pricing framework is the estimation of the instantaneous default probabilities for each obligor. As default probabilities depend on the credit quality of the considered obligor, well-calibrated credit curves are a main ingredient for constructing default times. Similarly, the choice of copula for modeling the correlation of obligors in the basket and the choice of procedures for rare-event simulation govern the pricing of basket credit derivatives. The study has several practical implications that are of value to the financial hedgers and engineers, financial regulators, government regulators, central banks, and financial risk managers.

The credit derivative and structured credit markets have grown very rapidly in size and complexity in recent years. The flourishing world of credit derivatives has in turn spurred huge growth in structured products. The demand for more tailored, tradable, and investment-grade instruments have been an important motivation for developments in the structured credit markets. The dominant structured product is basket credit default swaps and Collateralized Debt Obligation (CDO). The most common type of basket default swaps is the First-to-Default Swap (FTDS), where the seller compensates the buyer for any loss of the principal and also, possibly, the accrued interest of the asset in the reference basket which defaults first. The main difference between FTDS and a Credit Default Swap (CDS) is the event causing payout for the contract (in one case, it is the first default of any of a list of names and in the other default of a single name). An n^th to default basket default swap gives protection against the n^th default in the underlying pool of credits.

In order to understand the significance of developments in the Japanese markets, it is useful to review what is happening in the global market. The global market in credit derivatives is expected to rise to $33 tn by the end of 2008 according to a report to be published by the British Bankers' Association (BBA) at its Credit Derivatives conference. The report, based on a survey of market leaders in credit derivatives, predicts that London will remain as one of the world's dominant centers for credit derivative products. According to SIFMA^TM, Global CDO issuance through the third quarter of 2006, at $322 bn, has exceeded full-year 2005 issuance by 20%. Issuance in the third quarter of 2006, at $117.8 bn, also exceeded issuance in the third quarter of last year by 30%. European Sclerotisation Forum (ESF) forecasts issuance to grow to a new record of 531 bn in 2007, led by Residential Mortgage-Backed Securities (RMBS), Commercial Mortgage-Backed Securities (CMBS), and CDOs. Then, a 16.4% growth rate from 456 bn issued in 2006.

Basket Default Swap, Japanese Market, Collateralized Debt Obligation, CDO, First-to-Default Swap, FTDS, European Sclerotisation Forum, ESF, Residential Mortgage-Backed Securities, Commercial Mortgage-Backed Securities, CMBS, Credit ratings, Recovery rates, British Bankers Association, BBA.