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Credit Default Option

Credit default options are options to buy or sell protection through a credit default swap on a specific reference credit at a future date and strike price. Buying a payer option only protects against a rise in the credit spread, not an actual default, since the option is extinguished without payment upon default. Options on credit indices include defaulted entities in the option's value when exercised, providing "front-end protection." Properly valuing index options with front-end protection is complicated.

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73 views1 page

Credit Default Option

Credit default options are options to buy or sell protection through a credit default swap on a specific reference credit at a future date and strike price. Buying a payer option only protects against a rise in the credit spread, not an actual default, since the option is extinguished without payment upon default. Options on credit indices include defaulted entities in the option's value when exercised, providing "front-end protection." Properly valuing index options with front-end protection is complicated.

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BOBBY212
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Credit default option

In finance, a default option, credit default swaption or credit default option is an option to buy
protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference
credit with a specific maturity. The option is usually European, exercisable only at one date in the future at
a specific strike price defined as a coupon on the credit default swap.

Credit default options on single credits are extinguished upon default without any cashflows, other than the
upfront premium paid by the buyer of the option. Therefore, buying a payer option is not a good protection
against an actual default, only against a rise in the credit spread. This may explain why such options are
very illiquid. They may also feature quite high implied volatilities, as shown by Damiano Brigo (2005).
However options on credit indices such as iTraxx and CDX include any defaulted entities in the intrinsic
value of the option when exercised. This is expressed at times by stating that the options offer "front-end
protection". Proper inclusion of front end protection complicates index options valuation, see for example
Claus M. Pedersen (2003), or Brigo and Morini (2008).

See also
Option (finance)
Credit default swap
Credit derivative

References
Brigo, Damiano (January 2005). "Market Models for CDS Options and Callable Floaters".
Risk Magazine. Related Article at SSRN (http://ssrn.com/abstract=508922)
Pedersen, Claus M. (2003). "Valuation of Portfolio Credit Default Swaptions". Lehman
Brothers Quantitative Credit Research.
Brigo, Damiano and Massimo Morini (2008). "Arbitrage-free pricing of Credit Index Options.
The no-armageddon pricing measure and the role of correlation after the subprime crisis" (htt
ps://web.archive.org/web/20080925173753/http://orfe.princeton.edu/creditrisk/program.php).
Second Conference on the Mathematics of Credit Risk. Princeton University. Archived from
the original (http://orfe.princeton.edu/creditrisk/program.php) on 2008-09-25. Related SSRN
article at [1] (http://ssrn.com/abstract=1080064)

External links
John Hull and Alan White, The Valuation of Credit Default Swap Options (https://web.archiv
e.org/web/20110517003002/http://www.rotman.utoronto.ca/~hull/DownloadablePublication
s/HullWhiteCDSoptionspaper.pdf)

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