Credit Derivatives Pricing and Valuation1
In this chapter we look at the various approaches used in the pricing and valuation of credit derivatives. We consider generic techniques and compare prices obtained using different pricing models. We also present an intuitive look at pricing to illustrate the basic concept behind pricing a credit default swap (CDS).
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 used in 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 limitations of a pricing model. Issues to consider when carrying out credit derivative pricing include:
- implementation and selection of appropriate modelling techniques;
- parameter estimation;
- quality and quantity of data to support parameters and calibration;
- 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 payout on intermediate stages between the current state and default, then the important factor is the probability of default from the current state. An introduction to default probabilities is given at Appendix 6.1.
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