This thesis presents a standard market model for valuing European credit default swap options. A credit default swap (CDS) option is a credit derivatives contract whose underlying is a forward credit default swap. The valuation formula for CDS options is very similar to the model of European swaptions. Once default probabilities and expected recovery rates have been estimated, it enables traders to calculate option prices from credit default swap spread volatilities. To value an option price, implied default probabilities from CDS spreads were derived and used as a key variable. The CDS option price should reflect the fair market value of future cash-flows based on contingent claims between reference bond and forward credit default swap.
As a result of this study, it shows that the option price using Hull and White [2003] model is a little over-valued compared to the case. The option price was affected by the accrual interest on bond, spread volatility and discount factors. When we set the accrual interest equals zero, the option price was little changed. We assumed a LIBOR zero curve as a risk-free interest rate but in reality, there would exist a credit risk to be added. Besides, we should consider the transaction cost and the possible difference of modeling pricing tool. Compared credit spread with CDS spread, it seemed that the credit spread might be used as an indicator to find a fair value of CDS spread. In this thesis, we assumed recovery rate was given and tested sensitivity analysis. It showed that the effect to the option price was relatively small affected by trade-offs between default probability and payoff. The spread volatility was calculated from historically quoted spreads for the bond issued by the Rep. of Korea as a reference entity. As the market for CDS options becomes well established, it is likely that implied volatilities for CDS options will be produced in much the same way that implied volatilities are produced for options on other assets.
