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A CDS Option Miscellany

Richard J Martin

Abstract

CDS options allow investors to express a view on spread volatility and obtain a wider range of payoffs than are possible with vanilla CDS. We give a detailed exposition of different types of single-name CDS option, including options with upfront protection payment, recovery options and recovery swaps, and also presents a new formula for the index option. The emphasis is on using the Black-76 formula where possible and ensuring consistency within asset classes. In the framework shown here the `armageddon event' does not require special attention.

A CDS Option Miscellany

Abstract

CDS options allow investors to express a view on spread volatility and obtain a wider range of payoffs than are possible with vanilla CDS. We give a detailed exposition of different types of single-name CDS option, including options with upfront protection payment, recovery options and recovery swaps, and also presents a new formula for the index option. The emphasis is on using the Black-76 formula where possible and ensuring consistency within asset classes. In the framework shown here the `armageddon event' does not require special attention.

Paper Structure

This paper contains 19 sections, 43 equations, 2 figures, 1 table.

Table of Contents

  1. How CDS trade, and a new RPV01 formula
  2. Single-name options
  3. Knockout, running
  4. No-knockout, running
  5. Knockout, upfront+running
  6. Knockout, Standard American/European
  7. No-knockout, upfront+running
  8. Recovery swaps and options
  9. Example
  10. Index options
  11. General
  12. The forward spread
  13. Pricing model, 'simple' construction
  14. Put-call parity
  15. Price-quoted options
  16. ...and 4 more sections

Figures (2)

  • Figure 1: Vasicek distributions with mean 0.2 and width parameter 0.5, 0.6, 0.7.
  • Figure 2: Knockout and no-knockout option prices as a function of the upfront part of the strike; spot 500bp. Payers: $\circ$=KO, $\bullet$=NKO, both on LH axis. Receivers: $\square$=KO, $\blacksquare$=NKO, both on RH axis (they differ by $<0.1$bp). Running part of strike decreases linearly from 500bp to 0bp.