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Pricing corporate bonds, CDS and options on CDS with the BMC model

Author(s): D. Bloch Abstract: Academics have always occulted the calibration and hedging of exotic credit products assuming that credit models could be calibrated on vanilla products. However, in most markets one can only observe the five year CDS, forcing practitioners to make guesses and ignore the risk of default. We choose to address the calibration and hedging of exotic credit products by relating the credit spread to the equity volatility surface in an affine model. We briefly describe a jump-diffusion model with local intensity function of time and of the stock price. A change of measure using the cumulative survival probability is defined to simplify calculation. We then use it to price corporate bond and CDS prices and show that we get closed form solutions.We then extend the approach to price options on CDS. Calibration of the model parameters to liquid credit and equity information is discussed. 1 In... Pages: 11 Size: 383 kb Paper DOI: 10.2495/CF040091

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Download the Full Article This article is part of the WIT OpenView scheme and you can download the full text Adobe PDF article for FREE by clicking the 'Openview' icon to the right.