Pricing of Options on Credit Default Swaps

Malene Sloth Wilhelmsen

Student thesis: Master thesis

Abstract

An option on a Credit Default Swap (CDS) index is a financial product, that allows an investor to buy or sell the right to enter into a CDS index contract at a future point in time at a prespecified strike spread. In the aftermath of the global financial crisis the interest for buying CDS options has grown significantly. The main purpose of this master thesis is to describe and present a model for pricing options on Credit Default Swap (CDS) indices. In addition to this, the cause of the significant growth in the market for CDS option after the global financial crisis is investigated in order to achieve a greater understanding. The thesis consists of a theoretical and an empirical part. In the theoretical part CDS contracts and options on CDS contracts are described and a model for pricing options on single-name CDS contracts is derived based on the work of D. Brigo & M. Morini. The model is subsequently adjusted to price options on CDS indices according to D. O’Kane. In the empirical analysis options on the three indices Markit CDX.NA.IG, Markit iTraxx Europe and Markit iTraxx Crossover are priced during the global financial crisis (2008) and today (2017). Based on the results of the empirical analysis, it is concluded, that the model for pricing options on CDS indices is valid. By looking into the historical development of the credit volatility risk premium, which is the difference between the option implied and realised volatility, an understanding of why the market experienced such a significant growth after the end of the global financial crisis is achieved. The outcome from this investigation was, that the mainly positive credit volatility risk premium could have been attracting option sellers since the end of the global financial crisis. As the option market during the global financial crisis was having more natural option buyers compared to natural option sellers, this could be one of the explanations to why the market for CDS options experienced such a significant growth in the years after the crisis.

EducationsMSc in Business Administration and Management Science, (Graduate Programme) Final Thesis
LanguageDanish
Publication date2017
Number of pages114
SupervisorsMads Stenbo Nielsen