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Arbitrage-free Pricing of Credit Index Options: The no-armageddon pricing measure and the role of correlation after the subprime crisis

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  • Massimo Morini
  • Damiano Brigo

Abstract

In this work we consider three problems of the standard market approach to pricing of credit index options: the definition of the index spread is not valid in general, the usually considered payoff leads to a pricing which is not always defined, and the candidate numeraire one would use to define a pricing measure is not strictly positive, which would lead to a non-equivalent pricing measure. We give a general mathematical solution to the three problems, based on a novel way of modeling the flow of information through the definition of a new subfiltration. Using this subfiltration, we take into account consistently the possibility of default of all names in the portfolio, that is neglected in the standard market approach. We show that, while the related mispricing can be negligible for standard options in normal market conditions, it can become highly relevant for different options or in stressed market conditions. In particular, we show on 2007 market data that after the subprime credit crisis the mispricing of the market formula compared to the no arbitrage formula we propose has become financially relevant even for the liquid Crossover Index Options.

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File URL: http://arxiv.org/pdf/0812.4156
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Bibliographic Info

Paper provided by arXiv.org in its series Papers with number 0812.4156.

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Date of creation: Dec 2008
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Handle: RePEc:arx:papers:0812.4156

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Web page: http://arxiv.org/

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  1. Farshid Jamshidian, 2004. "Valuation of credit default swaps and swaptions," Finance and Stochastics, Springer, vol. 8(3), pages 343-371, 08.
  2. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330.
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Cited by:
  1. Jose Giancarlo Gasha & Andre Santos & Jorge A. Chan-Lau & Carlos I. Medeiros & Marcos Souto & Christian Capuano, 2009. "Recent Advances in Credit Risk Modeling," IMF Working Papers 09/162, International Monetary Fund.
  2. Rama Cont & Yu Hang Kan, 2011. "Dynamic hedging of portfolio credit derivatives," Post-Print hal-00578008, HAL.

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