Dynamic Modeling of Credit Derivatives

This chapter provides a simple model with a small number of parameters and a high degree of analytical tractability for a general option-based pricing of credits derivatives. It focuses on the comprehensive and (semi-)analytical description of credit-related assets (firm values), as well as corresponding Portfolios. The chapter presents the empirical properties of the model. It also presents a structural approach for the dynamics of credit-related assets within a CAPM-like framework. This setting enables the pricing of general single- and multiname credit derivatives, whereas the focus is on credit default swaps (CDS) and CDS indices. The chapter evaluates the model introduced by Kou, which describes the equity as well as the asset movements. It provides an outline of the contemplated credit derivatives and the underlying mechanism. The adopted modeling techniques are described. The main advantages of the approach are its economic validity, analytical tractability and the sparse number of parameters.