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Valuation of Credit Default Swaptions and Credit Default Index Swaptions

by Marek Rutkowski of the University of New South Wales, and
Anthony Armstrong of the University of New South Wales

July 5, 2008

Abstract: The paper provides simple and rigorous, albeit fairly general, derivations of valuation formulae for credit default swaptions and credit default index swaptions. Results of this work cover as special cases the pricing formulae derived previously by Jamshidian (2004), Pedersen (2003), Brigo and Morini (2005) and Morini and Brigo (2007). Most results presented in this work are completely independent of a particular convention regarding the specification of the fee and protection legs and thus they can also be used for valuation of other credit derivatives that exhibit similar features (for instance, options written on CDO tranches). The main tool is a judicious choice of the reference filtration combined with a suitable specification of the risk-neutral dynamics for the pre-default (loss-adjusted) fair market spread.

Keywords: credit default swaptions, credit default index swaptions.

Published in: International Journal of Theoretical and Applied Finance, Vol. 12, No. 7, (November 2009), pp. 1027-1053.

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