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A dynamic programming approach for pricing CDS and CDS options

Author

Listed:
  • Hatem Ben-Ameur
  • Damiano Brigo
  • Eymen Errais

Abstract

We propose a flexible framework for pricing single-name knock-out credit derivatives. Examples include Credit Default Swaps (CDSs) and European, American and Bermudan CDS options. The default of the underlying reference entity is modelled within a doubly stochastic framework where the default intensity follows a CIR++ process. We estimate the model parameters through a combination of a cross sectional calibration-based method and a historical estimation 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 rather than on the default event.

Suggested Citation

  • Hatem Ben-Ameur & Damiano Brigo & Eymen Errais, 2009. "A dynamic programming approach for pricing CDS and CDS options," Quantitative Finance, Taylor & Francis Journals, vol. 9(6), pages 717-726.
    • Handle: RePEc:taf:quantf:v:9:y:2009:i:6:p:717-726
    DOI: 10.1080/14697680802595619
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    References listed on IDEAS

    as
    1. Schönbucher, Philipp J., 2000. "A Libor Market Model with Default Risk," Bonn Econ Discussion Papers 15/2001, University of Bonn, Bonn Graduate School of Economics (BGSE).
    2. Hatem Ben-Ameur & Michèle Breton, 2004. "A Dynamic Programming Approach for Pricing Options Embedded in Bonds," Computing in Economics and Finance 2004 237, Society for Computational Economics.
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    Cited by:

    1. Richard J Martin, 2011. "A CDS Option Miscellany," Papers 1201.0111, arXiv.org, revised May 2019.

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