Portfolio default swaps segment the risk associated with a portfolio of credits linked to several credits among multiple investors. Portfolio default swaps are broken down into two main
categories: 1) first loss swaps; and 2) first-to-default swaps. First loss default swaps measure realized losses in dollars while first-to-default swaps measure losses in discrete events.
Portfolio default swaps can be traded outright or can be embedded in special purpose vehicles to create a funded asset. Default swaps based on portfolios use technology originated in the Collateralized Debt Obligation ("CDO") markets. The first-to-default or first loss swaps can be compared to the "equity" portion of a CDO. The second-to-default and second loss tranches of portfolio default swaps are analogous to the senior tranche of securitizations such as CDOs.
Buyers of portfolio default protection are motivated to retain a portion of the risk in existing portfolios and to reduce the absolute cost of hedging existing credit risk. Sellers of portfolio protection are attracted to the customized risk/return profile of the resulting exposure - the non-recourse, convex, enhanced spread of first loss positions and the over-collateralized low-risk nature of second loss positions.
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