On the Pricing of Credit Spread Options: A Two Factor HW–BK Algorithm

Joao B. C. Garcia (), Helmut van Ginderen () and Reinaldo C. Garcia ()
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Joao B. C. Garcia: Senior Quantitative Analyst, Risk Methodology, Dexia Holding, Square de Meeus 1, B-1012 Brussels, Belgium
Helmut van Ginderen: Risk Methodology, Dexia Bank, Galileilaan 5, B-1012 Brussels, Belgium
Reinaldo C. Garcia: Department Energy, Transportation and Environment, DIW - Deutsches Institut fur Wirtschaftsforschung, Königin Luise-Straβe 5, D 14195 Berlin, Germany

International Journal of Theoretical and Applied Finance (IJTAF), 2003, vol. 06, issue 05, 491-505

Abstract: In this article we describe what a credit spread option (CSO) is and show a tree algorithm to price it. The tree algorithm we have opted for is a two factor model composed by a Hull and White (HW) one factor for the interest rate process and a Black-Karazinsky (BK) one factor for the default intensity. As opposed to the tree model of Schonbucher 1999 the intensity process cannot become negative. Having as input the risk free yield curve and market implied default probability curve the model by construction will price correctly the associated defaultable bond. We then use Market data to calibrate the model to price an at the money (ATM) CSO call and then test it to price an out of the money (OTM) Bermudan CSO call on a CDS. Furthermore the discussions in this paper show in practice the difficulties and challenges faced by financial institutions in marking to market those instruments.

Keywords: Credit derivatires; credit risk; credit spreald options; implementation; Hull-White model; Black-Karazinsky model (search for similar items in EconPapers)
Date: 2003
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DOI: 10.1142/S0219024903002031

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