Credit default option
Encyclopedia
In finance
, 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
on a specific reference credit with a specific maturity. The option is usually European
, exercisable only at one date in the future at a specific strike price
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, of course. 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
(2005). However options on credit indices such as iTraxx
and CDX
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).
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a default option, credit default swaption or credit default option is an option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
to buy protection (payer option) or sell protection (receiver option) as a credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
on a specific reference credit with a specific maturity. The option is usually European
Option style
In finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American options. These options - as well as others where the...
, exercisable only at one date in the future at a specific strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
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, of course. 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
Damiano Brigo is an applied mathematician, and current Gilbart Chair of Financial Mathematics at King's College, London, known for a number of results in systems theory, probability and mathematical finance.-Main results:...
(2005). However options on credit indices such as iTraxx
Itraxx
iTraxx is the brand name for the family of credit default swap index products covering regions of Europe, Australia, Japan and non-Japan Asia. They form a large sector of the overall credit derivative market. The indices are constructed on a set of rules with the overriding criterion being that of...
and CDX
Credit Default Swap Index
A credit default swap index is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. Unlike a credit default swap, which is an over the counter credit derivative, a credit default swap index is a completely standardised credit security and may...
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).