FAST VALUATION OF FORWARD-STARTING BASKET DEFAULT SWAPS

Ken Jackson (), Alex Kreinin () and Wanhe Zhang ()
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Ken Jackson: Department of Computer Science, University of Toronto, 10 King's College Road, Toronto, ON, M5S 3G4, Canada
Alex Kreinin: Algorithmics Inc., 185 Spadina Avenue, Toronto, ON, M5T 2C6, Canada
Wanhe Zhang: Department of Computer Science, University of Toronto, 10 King's College Road, Toronto, ON, M5S 3G4, Canada

International Journal of Theoretical and Applied Finance (IJTAF), 2010, vol. 13, issue 02, 195-209

Abstract: A basket default swap (BDS) is a credit derivative with contingent payments that are triggered by a combination of default events of the reference entities. A forward-starting basket default swap (FBDS) is a BDS starting at a specified future time. Existing analytic or semi-analytic methods for pricing FBDS are time consuming due to the large number of possible default combinations before the BDS starts. This paper develops a fast approximation method for FBDS based on the conditional independence framework. The method converts the pricing of a FBDS to an equivalent BDS pricing problem and combines Monte Carlo simulation with an analytic approach to achieve an effective method. This hybrid method is a novel technique which can be viewed either as a means to accelerate the convergence of Monte Carlo simulation or as a way to estimate parameters in an analytic method that are difficult to compute directly. Numerical results demonstrate the accuracy and efficiency of the proposed hybrid method.

Keywords: Credit derivatives; forward-starting basket default swaps; conditional independence; hybrid methods (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1142/S0219024910005735

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