A dynamic programming approach for pricing CDS and CDS options

Hatem Ben-Ameur, Damiano Brigo and Eymen Errais

Quantitative Finance, 2009, vol. 9, issue 6, 717-726

Abstract: We propose a flexible framework for pricing single-name knock-out credit derivatives. Examples include Credit Default Swaps (CDSs) and European, American and Bermudan CDS options. The default of the underlying reference entity is modelled within a doubly stochastic framework where the default intensity follows a CIR++ process. We estimate the model parameters through a combination of a cross sectional calibration-based method and a historical estimation approach. We propose a numerical procedure based on dynamic programming and a piecewise linear approximation to price American-style knock-out credit options. Our numerical investigation shows consistency, convergence and efficiency. We find that American-style CDS options can complete the credit derivatives market by allowing the investor to focus on spread movements rather than on the default event.

Keywords: Credit derivatives; Credit default swaps; Bermudan options; Dynamic programming; Doubly stochastic Poisson process; Cox process (search for similar items in EconPapers)
Date: 2009
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DOI: 10.1080/14697680802595619

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