Pricing Credit Default Swaps with Option-Implied Volatility

Abstract

Using the industry benchmark CreditGrades model to analyze credit default swap (CDS) spreads across a large number of companies during the 2007–09 credit crisis, the authors demonstrate that the performance of the model can be significantly improved by calibrating it with option-implied volatility rather than with historical volatility. Moreover, the advantage of using option-implied volatility is greater among companies with more volatile CDS spreads, more actively traded options, and lower credit ratings.