CDS Market Formulas and Models

by Damiano Brigo of Banca IMI, and
Massimo Morini of the Università di Milano - Bicocca

September 2005

Abstract: In this work we analyze market payoffs of Credit Default Swaps (CDS) and we derive rigorous standard market formulas for pricing options on CDS. Formulas are based on modelling CDS spreads which are consistent with simple market payoffs, and we introduce a subfiltration structure allowing all measures to be equivalent to the risk neutral measure.

Then we investigate market CDS spreads through change of measure and consider possible choices of rates for modelling a complete term structure of CDS spreads. We also consider approximations and apply them to pricing of specific market contracts. Results are derived in a probabilistic framework similar to that of Jamshidian (2004).

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