A CDO Option Market Model for Standardized CDS Index Tranches

Abstract:     
This paper provides a Market Model which implies a dynamic for standardized CDS index tranche spreads, i.e. tranches which securitise CDS index series and dispose of predefined subordination. The central idea consists in defining the forward Fair Tranche Spread as a function of the numeraire used in a Black & Scholes closed-form market formula. Hence it becomes possible to select any martingale dynamics for the forward spread rate under the associated probability and one can derive multi-period dynamics of the forward Fair Tranche Spread for different forward-time horizons. This model is useful for pricing options on tranches with future Issue Dates as well as for modeling emerging options on structured credit derivatives. With the upcoming regulation of the CDS market in perspective, the model presented here is also an attempt to face the effects on pricing approaches provoked by an eventual Clearing Chamber . It becomes also possible to calibrate Index Tranche Options with bespoke tenors/tranche subordination to market data obtained by more liquid Index Tranche Options with standard characteristics.

Number of Pages in PDF File: 31

Keywords: CDO, CDS, Index Tranche, Market Model, Tranchespread, Forward

JEL Classification: G12, G13, C02, C19

working papers series