The Valuation of Credit Default Swap Options

One of the major financial market developments of the last few years has been extending derivatives technology to the realm of credit risk, with the “plain vanilla” product being the credit default swap (CDS). And as with earlier derivative innovations, more exotic flavors are rapidly being created. In this article, Hull and White present the basic valuation theory for forwards and options on credit default swaps. The two key aspects of risk in a CDS are the probability of a default and the recovery rate given a default. Interestingly, in calibrating the CDS forward and option models to market CDS spreads, the trade-off between the two risk elements makes model valuations quite insensitive to the specific assumption about recovery.