Fast Valuation of Forward-Starting Basket Default Swaps
International Journal of Theoretical and Applied Finance (IJTAF), 2010
Posted: 15 Jun 2010 Last revised: 21 Jun 2010
Date Written: March 1, 2010
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
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