In this second chapter on credit derivatives we look at the approaches used in their pricing and valuation. We consider generic techniques and also compare prices obtained using different models. In addition, we highlight the difference in the market between the cash and synthetic spread levels for the same reference name. This is known as the basis and should be observed closely in the market.
The pricing of credit derivatives should aim to provide a “fair value” for the credit-derivative instrument. In the sections below, we discuss the pricing models currently proposed by the industry. The effective use of pricing models requires an understanding of the models’ assumptions, the key pricing parameters, and a clear understanding of the respective limitations of the models. Issues to consider when carrying out credit-derivative pricing include:
- The implementation and selection of appropriate modelling techniques
- The estimation of parameters
- The quality and quantity of data to support parameters and calibration
- The calibration to market instruments for risky debt
For credit derivative contracts in which the payout is on credit events other than default, the modelling of the credit evolutionary path is critical. If, however, a credit derivative contract does not pay out on intermediate stages between the current state and default, then the important factor is the probability of default from the ...