5 - Credit Derivatives Pricing and Valuation

Abstract

This chapter discusses various approaches that are used in pricing and valuation of credit derivatives. The pricing of credit derivatives provides a “fair value” for the credit derivative instrument. The chapter considers several pricing models that are used in the credit derivative markets. The effective use of pricing models requires an understanding of the models' assumptions and the key pricing parameters, and a clear understanding of the limitations of a pricing model. There are several issues that should be considered while carrying out credit derivative pricing such as implementation and selection of appropriate modeling techniques, parameter estimation, quality and quantity of data to support parameters and calibrations, and calibration to market instruments for risky debt. For credit derivative contracts in which the payout is on credit events other than defaults, the modeling of the credit evolutionary path is critical. If a credit derivative contract does not pay out on intermediate stages between the current state and default, then the important factor is the probability of default from the current state. The chapter discusses generic techniques and compares the prices that are obtained using different pricing modes. It also presents an intuitive look at pricing credit-default swaps to illustrate the basic concept of pricing a credit-default swap.