The Credit Default Swap Option

Abstract

During the financial crisis the demand for exotic derivatives decreased. However, the market for exotic derivatives among them CDS options has grown tremendously ever since. This thesis presents a necessary guideline on how to investigate the market of a new instrument. In this thesis we will investigate the market for the Credit Default Swap Option - A credit instrument in which there exists very little literature about. I discuss the underlying Credit Default Swap, the market for the CDS and the market for the CDS option. Combining extensive literature on valuing CDS options I arrive at an extension of the Black- Scholes formula. Thereby I succeed in pricing the CDS option. Empirically I manage to successfully calibrate the survival probability of a reference entity and by that I am able to calculate the option price on a CDS. I hope with this thesis that I can discover if the CDS option makes a di↵erence – in terms of money or risk - to investors, financial institutions, companies or even to private individuals. Using data from the CDS option market I expect to find both signs of speculative trading and indications that investors use the CDS option to reduce risk exposure.