Credit default option
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finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
, 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 A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
on a specific reference credit with a specific maturity. The option is usually
European European, or Europeans, or Europeneans, may refer to: In general * ''European'', an adjective referring to something of, from, or related to Europe ** Ethnic groups in Europe ** Demographics of Europe ** European cuisine, the cuisines of Europe ...
, exercisable only at one date in the future at a specific
strike price In finance, the strike price (or exercise price) of an option is a fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. The strike price may be set b ...
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 Damiano Brigo (born Venice, Italy 1966) is an applied mathematician and Chair in Mathematical Finance at Imperial College London. He is known for research in filtering theory and mathematical finance. Main results Brigo started his work with the ...
(2005). However options on credit indices such as
iTraxx iTraxx (Thomson Reuters Eikon code 'ITRAXX'; Bloomberg code 'ITRX') is the brand name for the family of credit default swap index products covering regions of Europe, Australia, Japan and non-Japan Asia. Credit derivative indexes form a large se ...
and
CDX The Cdx gene family, also called caudal genes, are a group of genes found in many animal genomes. Cdx genes contain a homeobox DNA sequence and code for proteins that act as transcription factors. The gene after which the gene family is named (the ...
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) In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date ...
*
Credit default swap A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
*
Credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the ''credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a cor ...


References


Related Article at SSRN
* * Related
SSRN The Social Science Research Network (SSRN) is a repository for preprints devoted to the rapid dissemination of scholarly research in the social sciences, humanities, life sciences, and health sciences, among others. Elsevier bought SSRN from So ...
article a


External links

* John C. Hull (economist), John Hull and Alan White
The Valuation of Credit Default Swap Options
Options (finance) Credit risk {{econ-stub