Pricing credit spread option with Kalman filter and Monte Carlo simulation

Abstract

This paper presents a method of pricing credit spread option on the basis of multiple factors affine term structure model of interest rates with Kalman filter and Monte Carlo simulation. In this way, the term structures of the Aaa corporate bonds and the Treasury debts with the same maturity in interbank market of China are obtained. Then the credit spreads of corporate bonds are obtained. So European credit spread put option can be priced according to the definition of pricing option. The correlations of option price and strike spread, option expiration are considered. The results show that the return of the credit spread put option increases when the strike spread decreases. The market prices of corporate bonds have a negative correlation with the market spreads. Due to different option expirations, the prices of corporate bonds will be distinct, and so will be the credit spread option prices.