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An Introduction To Pricing Methods For Credit Derivatives: José Figueroa-López

This document provides an introduction to pricing methods for credit derivatives. It discusses what credit derivatives are and gives examples like credit default swaps and collateralized debt obligations. It also summarizes how to price simple credit derivatives using the martingale or risk-neutral valuation method. Finally, it discusses challenges in pricing more complex multi-name credit derivatives that involve modeling correlated default times across multiple reference entities.

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40 views

An Introduction To Pricing Methods For Credit Derivatives: José Figueroa-López

This document provides an introduction to pricing methods for credit derivatives. It discusses what credit derivatives are and gives examples like credit default swaps and collateralized debt obligations. It also summarizes how to price simple credit derivatives using the martingale or risk-neutral valuation method. Finally, it discusses challenges in pricing more complex multi-name credit derivatives that involve modeling correlated default times across multiple reference entities.

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sam4report
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We take content rights seriously. If you suspect this is your content, claim it here.
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An introduction to pricing methods for credit

derivatives

José Figueroa-López1

1
Department of Statistics
Purdue University

Computational Finance Seminar


Purdue University
Feb. 22, 2008s
Credit derivatives

1 What are they?


• Securities used to manage and trade “credit risk" of firm; e.g. the risk that
the firm will default in a debt contract.
• The payoff of a credit derivative depends on the occurrence of a credit event
affecting a financial entity; e.g. Payoff triggered by a default event.
2 Two important examples: Credit Default Swaps (CDS) and Collaterized
Debt Obligations (CDO).
3 Credit Default Swaps:
• The most important derivative (2002: accounting for about 67% of the credit
derivatives market).
• Over-the-counter market for CDS written on large corporations is fairly liquid.
• Natural underlying security for more complex credit derivatives.
• CDS quotes data are used to calibrate pricing methods.
Credit Default Swaps
1 Three entities: A protection buyer, B protection seller, and C the
reference entity.
2 A contract where A pays periodic premium payments until maturity or
until the default of C;
3 If C defaults, B pays A a default payment (for instance, default payment
could mimic the loss that A suffers on a bond issue by C to A).
4 The premium payments are quoted in annualized percentage x ∗ of the
notional value of the reference asset. This rate x ∗ is called the CDS
spread.
A simple example
1 Set-up:
• Zero-coupon bond exposed to default, with maturity T = 1
• Recovery rate 1 − δ = 60%
• Objective default probability p = 1%
• Current price of defaultable bond is .941.
• A “risk-free" default-free zero-coupon bond with interest rate 5%.
• Current price of default-free bond is (1.05)−1 = .952.

2 Default put option:


• This contract pays 1 dollar if the bond defaults and pays 0 otherwise.
• This can be thought as a simplified CDS with only one premium
Pricing and hedging of the Default Put Option

1 Fundamental problems of finance:


• What is the fair price of the credit derivative?
• Is it possible to replicate the payoff of the derivative trading on the
underlyings?
2 Answers:
• Replicating portfolio:
• Go short 2.5 dollars in the defaultable bond
• Put 50/21 ≈ 2.38 dollars in the default-free bond
• Time t = 1 value of the portfolio
(
(−2.5)(1) + ( 50
21
)(1.05) = 0 if no default
V1 = 50
(−2.5)(.6) + ( 21 )(1.05) = 1 if default

• Time t = 0 initial endowments for portfolio:


50
V0 = (−2.5)(.941) + ≈ .0285.
21
• Arbitrage-free price of the option: P(0) = .0285.
Martingale or Risk-neutral valuation

Fundamental question:
Is the price consistent with the “martingale method"?

Martingale Method:
1 Calibration: Determine a measure Q so that all traded assets are
martingales:
 
Q Value at expiration
Initial market price = E
Value of $1 at expiration

0.6 1
.941 = ·q+ · (1 − q) =⇒ q = .03
1.05 1.05
2 Risk-neutral pricing:

1 0
P(0) = E Q {Discounted payoff} =⇒ P(0) = .03 + · .97.
1.05 1.05
Reduced-form model for CDS

1 Fundamental assumption: The objects of interest are directly modeled


under the risk-neutral probability measure Q.
2 Objects of interest:
• A (deterministic) risk-free (default-free) bond market with short-interest rate
r (t); that is, the time 0 price of a ZCB with maturity t is
Rt
P0 (0; t) = e− 0 r (s)ds
.

• δ=Recovery rate if default (deterministic).


• τ =random default time of the reference entity.

3 Specification of the CDS:


• Payments of premium are due at 0 < t1 < · · · < tN = T .
• If tk < τ , protection buyer (A) pays premium x ∗ (tk − tk −1 ) to protection seller
(B) at time tk . x ∗ is called swap spread.
• If τ ≤ T , then B makes the default payment δ to A at times τ .
• x ∗ is set so that the value of the CDS contract at time t = 0 is equal to 0.
Pricing of CDS
1 Pricing:
• Value of the premium payment leg:
N
X
V prem (x) = p0 (0, tk )(tk − tk −1 )Q(τ > tk ).
k =1

• Value of the default payment leg:


Z tN Rt
V def = δ fτ (t)e− 0 r (s)ds
dt,
0

where fτ is the density of τ under Q.


• The fair (arbitrage-free) CDS spread x ∗ is such that

V prem (x ∗ ) = V def .

2 A common model: Default time τ is given in terms of its “hazard rate”


γ Q (t):
Rt
γ Q (t)dt 1
P(τ > t) = e− 0 ⇐⇒ lim Q(τ ≤ t + δ|τ > t) = γ Q (t).
δ→0 δ
What about multi-name credit derivatives?

1 Suppose that we are interested in trading and managing the credit risk of
several firms.
2 An example:
• Say that we bear a portfolio consists of m corporate bonds issued by firms
with corresponding default times τ1 , . . . , τm .
• Our “exposure" to firm i is ei .
• The recovery rate if firm i defaults is δi .
• The total loss at time t will be
m
X
Lt = δi ei 1{τi ≤t} .
i=1

• What will be the distribution of the total loss if the firms are correlated?
• How to model the dependence between the default times?
Bibliography I

McNeil, Frey, and Embrechts.


Quantitative risk management.
Princeton, 2005.
Brigo and Mercurio
Interest rate models - Theory and Practice. With Smile, Inflation, and
Credit.
Springer, 2006.

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