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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.

Suggested Citation

  • Massimo Morini & Damiano Brigo, 2008. "Arbitrage-free Pricing of Credit Index Options: The no-armageddon pricing measure and the role of correlation after the subprime crisis," Papers 0812.4156, arXiv.org.
  • Handle: RePEc:arx:papers:0812.4156
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    File URL: http://arxiv.org/pdf/0812.4156
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    References listed on IDEAS

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    1. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330.
    2. Farshid Jamshidian, 2004. "Valuation of credit default swaps and swaptions," Finance and Stochastics, Springer, vol. 8(3), pages 343-371, August.
    3. Paul Glasserman & Wanmo Kang & Perwez Shahabuddin, 2007. "Large Deviations In Multifactor Portfolio Credit Risk," Mathematical Finance, Wiley Blackwell, vol. 17(3), pages 345-379.
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    Cited by:

    1. Rama Cont & Yu Hang Kan, 2011. "Dynamic hedging of portfolio credit derivatives," Post-Print hal-00578008, HAL.
    2. Jose Giancarlo Gasha & Andre O Santos & Jorge A Chan-Lau & Carlos I. Medeiros & Marcos R Souto & Christian Capuano, 2009. "Recent Advances in Credit Risk Modeling," IMF Working Papers 09/162, International Monetary Fund.

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