A Dynamic Programming Approach for Pricing CDS and CDS Options

22 Pages Posted: 6 May 2005

See all articles by Eymen Errais

Eymen Errais

Stanford University

Hatem Ben Ameur

HEC Montreal - Department of Management Sciences

Damiano Brigo

Imperial College London - Department of Mathematics

Date Written: March 12, 2006

Abstract

We propose a general setting for pricing single-name knock-out options. Examples include Credit Default Swaps (CDS), European and Bermudan CDS options. The default of the underlying reference entity is modeled within a doubly stochastic framework where the default intensity follows a CIR++ process. We estimate the model parameters through a combination of a calibration-based method and a historical approach. We propose a numerical procedure based on dynamic programming and a piecewise linear approximation to price American-style knock-out credit options. Our numerical investigation shows consistency, convergence and efficiency. We find that American-style CDS options can complete the credit derivatives market by allowing the investor to focus on spread movements and not credit default.

Keywords: Credit Derivatives, Credit Default Swaps, Bermudan Options, Dynamic Programming, Doubly Stochastic Process, Cox Process

JEL Classification: G12, G13

Suggested Citation

Errais, Eymen and Ben Ameur, Hatem and Brigo, Damiano, A Dynamic Programming Approach for Pricing CDS and CDS Options (March 12, 2006). Available at SSRN: https://ssrn.com/abstract=715801 or http://dx.doi.org/10.2139/ssrn.715801

Eymen Errais (Contact Author)

Stanford University ( email )

Stanford, CA 94305
United States

Hatem Ben Ameur

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada
514-340-6480 (Phone)
514-340-5634 (Fax)

Damiano Brigo

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

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