The Valuation of Credit Default Swap Options
Abstract: Now that the market for credit default swaps is well established, trading is increasing in forward credit default swaps and European credit default swap options. This article develops models for valuing these instruments. The model for valuing European credit default swap options is very similar to the standard market model for valuing European swaptions. Once default probabilities and expected recovery rates have been estimated, it enables traders to calculate option prices from credit default swap spread volatilities and vice versa. The article concludes by presenting numerical results illustrating the properties of the models and estimating spread volatilities from historical data.
Published in: Journal of Derivatives, Vol. 10, No. 3 (Spring 2003), pp. 40-50.