Options On Credit

Default Index Swaps*

Yunkang Liu and Peter Jäckel
Credit, Hybrid, Commodity and Inflation Derivative Analytics
Structured Derivatives
ABN AMRO
250 Bishopsgate
London EC2M 4AA
Abstract: The value of an option on a credit default index swap consists of two parts. The first one is the protection value due to potential default of the reference names
before option expiry date. The second one depends on the value of the underlying credit default index swap where the index consists of the remaining survived names at the
option expiry date. This article presents a valuation framework driven by the distribution of the credit default index swap rate conditioned on the state of the reference pool
at the option expiry date. As an example, the one-factor Gaussian Copula is used to model the state of the reference pool of the index at the option expiry date. Conditional on
the state of the reference pool at the expiry date, the option is valued under the assumption that the conditional forward credit default index swap rate follows a displaced
diffusion (shifted lognormal) law.

receive an up-front amount to enter a contract. For instance, if an index

1 Introduction
A credit default swap on an index (CD index swap) is to some extent sim-
ilar to a single name credit default swap (CDS). The index is a portfolio of
defaultable reference names with equal weights. Like a single name CDS,
a CD index swap consists of a protection leg and a premium leg. The cash
flows on the protection leg are contingent on losses incurred from cred-
it events of the reference names. The premium leg consists of scheduled
coupon payments with a fixed coupon rate. The sizes of these cash flows
depend on the recovery rate and the notional amount outstanding. For
example, consider an index of 100 reference names with a total notional of
100 millions, if one name defaults then the notional amount for premium
calculation will be reduced by one million, the protection buyer will deliv-
er one million principal amount of the bonds of the reference name suf-
fering the credit event to the protection seller in return for one million in
cash. A CD index swap usually carries a fixed coupon rate. When it is trad-
ed on the market at a different level, there is a requirement to pay or
has a fixed coupon of 100 basis points (bps) and it is traded at 110bps then
the protection seller will receive an up-front cash payment equivalent to
10bps for the duration of the contract. This up-front payment is usually
calculated using Bloomberg’s CDS pricer.
Options on CD index swaps give investors the right to buy or sell risks
at the strike spread. A payer swaption is an option that gives the holder
the right to be the premium payer (protection buyer), while a receiver
swaption holder has the right to be the premium receiver (protection
seller). A payer swaption is often referred to as a put (right to sell risk), a
receiver swaption as a call (right to buy risk). Also traded on the market
is a straddle which entitles the holder to choose whether to buy or to sell
risk at a specified strike spread. Options on CD index swaps are traded as
knock-in. In the case of a payer swaption, should the option holder exer-
cise it at the expiry date the holder will be compensated for losses
incurred from any default of the reference names between the trade date
and the expiry date. In the case of a receiver swaption, the option holder

*The authors thank Constantinos Katsileros, Sam Phillips, Ebbe Rogge and Martijn van der Voort for their valuable comments and suggestions.

92 Wilmott magazine
 TECHNICAL ARTICLE 6

will have to pay for the losses should he exercise the option. By contrast,
a swaption on a single name CDS is usually traded as knock-out, i.e. if the
reference name defaults before the option expiry date the trade is termi-
nated and there is no exchange of cash flows. A knock-in payer swaption
is always more valuable than its knock-out version. For a CD index swap,
a knock-in receiver swaption is less valuable than its knock-out version.
This paper deals with the pricing of options on CD index swaps.
Section 2 presents a valuation framework driven by the distribution of
the credit default index swap rate conditioned on the state of the refer-
ence pool at the option expiry date. By conditioning the option price on
the state of the reference pool we have effectively followed the survival
measure approach used by [Schönbucher 2003] for pricing options on sin-
gle name CD swaps. Section 3 presents an alternative pricing model that
is currently used by some market practitioners.
2 A Survival Measure Based Option
before the option expiry date, the reference pool contains fewer reference
names at the option expiry date T than at the valuation date. For this rea-
son, the valuation of the option should be conditional on the state of the
reference pool at the expiry date. Let N be the notional amount of each
name and M the number of reference names remaining at the valuation
date. Denote by m the set of exactly m defaults in the reference pool
between the valuation date and the option expiry date T . Noting that the
reference pool is assumed to be (or approximated by) a homogenous one, it
suffices to consider the state of the portfolio m for 0 ≤ m ≤ M . Conditional
on the reference pool being in a state in m at the expiry date T, the value at
time t ≤ T of the underlying index swap to the protection buyer is
(M − m)N[B(t) − CA(t)], (3)
where
1 1
A(t) = B(t) =
1 − p(t, T)
Ā(t),
1 − p(t, T)
B̄(t) (4)

Pricing Model
Consider a forward-starting CD index swap with a forward start date t0 ,
coupon payment dates t1 , . . . , tn , and a fixed coupon rate of C. The index
is treated as if it were a single name for the purpose of making assump-
tions on the recovery rate and for bootstrapping the default probability
from the market prices of traded index swaps. This is equivalent to
approximating the underlying reference pool with a homogeneous one.
We will comment on the non-homogeneous case at the end of this sec-
tion. Furthermore, the interest rate and default intensity are assumed to
be independent from each other.
are the annuity and protection value per unit notional conditional on
the survival of the rest of the reference names at the expiry date T . It is
the division by 1 − p(t, T), the survival probability at T , in (4) that turns
the risky annuity and protection value into annuity and protection value
conditional on survival at T .
In the case of a payer swaption with a strike coupon rate of K , the m -
conditional pay-off at T is
max((M − m)N[B(T) − CA(T) + (C − K)Ã] + Lm , 0), (5)
where

Denote Lm = L̄ + (1 − R)mN (6)

δi the year fraction between ti−1 and ti , is the aggregated loss due to default with L̄ being the accumulated loss
D(t, u) the risk free discount factor, i.e., the price at t of a due to default between the trade date and the valuation date t, and
zero bond that pays 1 at u,   

n ti
u − ti−1
R the recovery rate of a reference name, Ã = δi D(t0 , ti )(1 − p̃(t0 , ti )) + D(t0 , u)dp̃(t0 , u) (7)
p(t, u) the default probability at time u ≥ t of a reference name ti− 1 ti − ti−1
i=1
conditional on survival at t
is a risky annuity with p̃(t0 , t) being the default probability bootstrapped
and for t ≤ t0 let from a flat CDS curve with CDS rates fixed as K . The quantity (C − K)Ã
   represents the upfront cash settlement value per unit notional to the

n ti
u − ti−1
Ā(t) = δi D(t, ti )(1 − p(t, ti )) + D(t, u)dp(t, u) (1) payer for entering a CD index swap with a fixed coupon C, even though K
ti− 1 ti − ti−1 is the agreed coupon rate by the payer and the receiver of the swap. We
i=1
note that had it been settled according to the index CDS curve at T the
be the risky annuity1, and m -conditional pay-off would simply be
 tn
B̄(t) = (1 − R) D(t, u)dp(t, u) (2) max((M − m)N[B(T) − KA(T)] + Lm , 0). (8)
t0
On the other hand, when the strike K is close to either the fixed coupon
the expected value of the protection per unit notional. Because of the rate C or the forward rate S(t), (8) is a good approximation of (5). For
assumption that the interest rate is independent of the default intensity, 0 ≤ m < M , by using A(t) as the numéraire, we see that the value at time
the discount factor D(t, u) is assumed to be deterministic. t of the m -conditional pay-off is
^
Let us consider an option to enter the aforementioned CD index swap at
the expiry date T = t0 . If there are defaults amongst the reference names Vmpayer (t) = (M − m)NA(t)E M(A) max(S(T) − cm , 0)], (9)

Wilmott magazine 93
 where M(A) is the probability measure generated by the survival annuity Similarly, we find the value at time t of a receiver swaption as
A(t), the forward rate

M−1

S(t) = B(t)/A(t) (10) V receiver (t) = Pm (M − m)NA(t)(1 + bm )E M(A) [max(Km − S(T), 0)]. (20)
m=0
is defined as the coupon rate that makes the underlying swap (3) worth-
less at time t, and It can be seen from the following identities

(C − K)(M − m)N Ã + Lm 
M 
M
cm = C − . (11) Pm = 1, mPm = Mp(t, T), E M(A) [S(T)] = S(t) (21)
(M − m)NA(T)
m=0 m=0
To be able to calculate the value of the pay-off, we need to express 1/A(T)
in cm in terms of S(T). Motivated by the linear swap rate model [Hunt and that the values of payer and receiver swaptions obey a call-put parity of
Kennedy 2000], we propose the following approximation the form

D(u, T) V payer (t) − V receiver (t) = MN Ā(t)(S̄(t) − K), (22)

≈ a(t) + b(t)S(u), t ≤ u ≤ T, (12)
A(u) where
where (L̄/MN + (1 − R)p(t, T))D(t, T)
  +(C − K)(ÃD(t, T) − A(t))(1 − p(t, T))
D(t, T) 1 D(t, T) S̄(t) = S(t) + (23)
a(t) = , b(t) = − a(t) . (13) (1 − p(t, T))A(t)

n
S(t) A(t)
δi D(t, ti )
i=1
is the default-and-settlement-adjusted forward rate, recalling that Ā, A
and S are defined in (1), (4) and (10), respectively. Because of this call-put
Roughly speaking, a(t) is chosen so that both sides of (12) match when parity we only consider payer swaptions in the rest of this paper. For ease
p(u, v) = 0 and thus S(u) = 0 for v ≥ u ≥ t , and b(t) is chosen so that of comparison, we shall call a CD index swaption at-the-money if the
  default-and-settlement-adjusted forward rate S̄(t) equals the strike K .
D(t, T) D(T, T)
= E M(A) = E M(A) [a(t) + b(t)S(T)] = a(t) + b(t)S(t), (14) Empirical research such as [McGinty and Watts 2003] suggests that
A(t) A(T)
the dynamical behaviour of credit default swap rates tends to be complex
and neither completely lognormal nor normal. In general, it is close to a
noting that D(u, T)/A(u) and S(u) are martingales under the probability
normal distribution for high credit quality reference names and to a log-
measure M(A). Hence,
normal distribution for low quality reference names. Therefore, a reason-
E M(A) [max(S(T) − cm , 0)] = (1 + bm )E M(A) [max(S(T) − Km , 0)], (15) able assumption might be that given t as the valuation date, S(u) follows
the law generated by a displaced diffusion process
where
dS(u) = σ [βS(u) + (1 − β)S(t)]dWu , t≤u≤T (24)
(C − K)(M − m)N Ã + Lm
bm = b(t) (16)
(M − m)N where β ≥ 0 is a displacement parameter and σ is a volatility parameter.
and Note that there is no drift term in (24) because the swap rate we are con-

 cerned with is a martingale with respect to the probability measure M(A).
1 (C − K)(M − m)N Ã + Lm When β = 1, the process (24) is lognormal. When β = 0, it becomes a nor-
Km = C− a(t) . (17)
1 + bm (M − m)N mal process. The displaced diffusion process is frequently used as a con-
venient method to model implied volatilities both in the equity option
There is no swap left when all the reference names default before T . Thus, markets as a result of leverage [Rubinstein 1983], and for interest rate deriv-
the value at time t of the M -conditional pay-off is atives [Khuong-Huu 1999]. A discussion of the displaced diffusion process
VM
payer
(t) = LM D(t, T). (18) and its properties can be found in [Jäckel 2002], [Rebonato 2002] and many
other reference books. However, one needs to take extra care in the case of
To summarize, the value at time t of the payer swaption is β < 1, since the swap rate S(u) modelled by (24) can be negative with a

M−1 small but positive probability. The beauty of using the displaced diffusion
V payer (t) = Pm (M − m)NA(t)(1 + bm )E M(A) [max(S(T) − Km , 0)] process is that it is no harder to get analytic option price formulae than it
m=0 (19) is in the case of a lognormal process. Knowing that (βS(u) + (1 − β)S(t)) is
+ PM LM D(t, T), lognormal when β > 0 and that S(u) is normal when β = 0, we have

where Pm denotes the probability of m . E M(A) max(S(T) − Km , 0)] = Call(S(t), Km , T − t, σ, β), (25)

94 Wilmott magazine
 TECHNICAL ARTICLE 6

where we define Example 1. To illustrate the impact of the correlation parameter ρ on

  σ √ TS − 1 d2
the option price, we consider payer swaptions that give the option hold-
 √ 2π e 2 3 − (K − S)(d3 ) , β=0
  ers the right to buy protection in three months time on a 4 Year 9 Month
Call(S, K, T, σ, β) = 1
S(d1 ) − Kβ (d2 ) , β > 0, Kβ > 0 (26)
 β index CD swap. Suppose the index consists of 30 reference names with a
S − K, β > 0, Kβ ≤ 0 total notional of 10 million. It is traded at 100bps flat and is assumed to
with Kβ = βK + (1 − β)S , and have 40% recovery rate. The interest swap rate is 4%. The model parame-
ters are σ = 50% and β = 1. Figure 1 shows that correlation has little
log(S/Kβ ) 1 √ √ S−K effect on the option value unless it is deeply out-of-money.
d1 = √ + βσ T, d2 = d1 − βσ T, d3 = √ . (27)
βσ T 2 σ TS
Example 2. When β = 1, the option pricing model presented here can
In order to calculate the distribution of the number of defaults at the generate volatility skews, i.e., the implied Black volatility (the equivalent
expiry T in a way that is consistent with the market practice for CDO volatility for β = 1) can display certain levels of skewness. Consider the
tranche pricing, we choose the homogeneous one-factor Gaussian Copula same put option as in Example 1 but priced with ρ = 20% and different
model (see, e.g., [Schönbucher 2003]), noting that the reference pool is values of β . Figure 2 shows that the two different shapes of skewness, one
treated as a homogeneous one. Let ρ ≥ 0 be a correlation parameter,  for β < 1 and the other for β > 1.
the cumulative density function of the standard normal distribution,
To model volatility smiles, one may choose to replace the displaced
and
 −1 √  diffusion law generated by process (24) with stochastic volatility models
 (p(0, T)) − ρx such as Heston or SABR. Due to the simple and modular setup of our
q(x) =  √ (28)
1−ρ approach, the Heston or SABR densities can be used as a drop-in replace-
ment for the distribution of the forward credit index default swap rate.
the default probability at time T conditional on a given sample x of the One may also choose to model the state of the portfolio at the option
standard normal distribution. Then expiry date using a different type of copula. After all, the copula model is
  ∞ merely used to generate the distribution of the number of defaults at the
M
Pm = q(x)m (1 − q(x))M−m ϕ(x)dx, m = 0, 1, · · · , M, (29) option expiry.
m −∞

where ϕ is the density function of the standard normal distribution. We

note that the integral in (29) can be solved numerically 100,000
with Gauss-Hermite quadrature (see, e.g., [Press et al
1992]). For a short-dated option, it is reasonable to 90,000
assume that Pm is very small for large m. Hence, one Strike=90bps

may choose ρ to be the implied correlation of the trad- 80,000 Strike=100bps

Strike=110bps
ed equity tranche of the corresponding index. Strike=120bps
70,000 Strike=130bps
By combining formulae (19), (25), and (29), we are Strike=140bps
Option Value

able to price payer swaptions on credit default indices. 60,000 Strike=150bps

The resulting formula resembles the equity call option

formula in [Merton 1976, 1990] where the underlying 50,000
process is assumed to be a jump diffusion of the form
40,000
dS(t)
= µdt + σ dWt + (J − 1)dN(t) (30)
S(t) 30,000
where J is the jump size, N(t) is a Poisson process. Of 20,000
course, in our case there are only a finite number of
jumps, each jump corresponds to a state of the refer- 10,000
ence pool at the option expiry, the sizes of these
jumps are not identical, and the arrival of the jumps -
are not Poisson. It is worth noting that (19) is a gener- 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
ic pricing formula and one can choose a different Correlation
^
model for calculating Pm and a different distribution
law for S(T). Figure 1: Sensitivity to correlation.

Wilmott magazine 95
 60% 3 An Alternative Approach
58% The expected pay-off of a payer CD swaption at the expiry
Beta=0
date T can be written as
Beta=0.4
56% Beta=0.8
MN max(B̄(T) − K Ā(T), 0)) = MN Ā(T)max(S̄(T) − K, 0)), (31)
Beta=1.2
Implied Black Volatility

54% Beta=1.6
52%
50%
48%
46%
44%
42%
40%
70 80 90 100 110 120
Strike (bps)
Figure 2: Volatility Skew.
The ideas presented in this section can be extended to cover the
case when the reference pool is not homogeneous. If the reference
pool is relatively homogeneous, we can approximate the pool by an
homogeneous one and then price the option accordingly. Otherwise,
we need to condition the option pricing on all the distinguishable
states of the reference pool instead of merely on the number of
defaults. The total number of distinguishable states is 2M , which can
be very large even for a relatively small M such as 30 (the number of
names for the DJ iTraxx Europe HiVol and the Crossover indices). To be
computationally practical, one may have to approximate the original
reference pool by a homogeneous pool for cases where there are more
than a couple of defaults. In either case, we may have to make adjust-
ment to the CDS curves of the underlying reference names. This is
because, while we can infer the fair credit default swap rate of an
index CD swap directly from the CDS curves of the underlying refer-
ence names, the market may trade the index swap at a different level
due to liquidity issue and different definitions of credit event for
indices and for single names.
We emphasize that we have not made any attempt to model the effect
of the default of any single name on the remaining survival names, a sub-
ject that is both difficult and interesting. However, recent events such as
the default of Pamalat show that it is questionable whether the default of
one name needs to be modelled as causing significant spread jumps to
other names within a portfolio of names.
recall that Ā and S̄ are defined in (1) and (23), respectively.
Assuming the default_and_settlement_adjusted forward rate
S̄(t) follows the displaced diffusion process (24), by using Ā(t) as
a “numéraire” we find that the present value of the pay-off is
MN Ā(t)Call(S̄(t), K, T − t, σ, β). (32)
The payer swaption is effectively valued by conditioning on
the “expected state’’ of the reference pool at the expiry date.
Note that the adjusted forward S̄(t) is like a big carpet where
the default and settlement adjustments are put underneath it.
The lognormal case of (32) or its variations seem to be
popular with some market practitioners. Because of its sim-
plicity, (32) is a suitable candidate for quoting purposes.
130 140 However, it does have problems, in theory as well as in prac-
tice, for CD index swaption valuation.
First of all, there is a technical flaw in the derivation of
(32) in that the risky annuity Ā(t) is not a valid numéraire
since it can become zero upon the default of all underlying assets (read-
ers are referred to [Schönbucher 2003] for an excellent discussion on the
survival measure approach for pricing of single name CD swaption.). In
the special case of an index with a single reference name (M = 1 and
K = C ) the pricing formula (32) is inconsistent with the obvious choice
N Ā(t)Call(S(t), K, T − t, σ, β) + (1 − R)Np(t, T)D(t, T), (33)
which is simply the option value in the knock-out case (see, e.g., [Hull and
White 2002]) and [Schönbucher 2003] for the lognormal case) plus the
present value of the expected loss due to default by the option expiry date.
Even though the model parameters σ and β in (32) have slightly different
meanings from those in (33), it does show that (32) is less than ideal.
Secondly, (32) may not be adequate in capturing the distributional
nature of the number of default at the option expiry, especially when the
option is deeply out-of-money. To be more precise, (32) may underesti-
mate the values of out-of-money options as is shown by the following
example.
Example 3. Consider a payer swaption that gives the option holder the
right to buy protection at 200bps in three months time on a 4 Year 9
Month CD index swap of two reference names with a total notional of 10
million and a fixed coupon rate of 100bps. Assume that the interest rate is
4% and both reference names’ CDS curves are traded at 100bps flat and are
assumed to have 40% recovery rate. This means that the probability of a sin-
gle name default within 3 months is approximately 1 − exp(−0.01/
(1 − 0.4) ∗ 0.25) ≈ 0.42% , the forward swap rate for the index is 100bps,
the default-adjusted forward swap rates is 106bps, and the annuity is 4.15.

96 Wilmott magazine

Let us estimate the option value from first principles. If there is one default
before the option expiry and the CDS spread on the remaining survived
name has not changed dramatically, the option holder would exercise the
option to receive a protection payment of (1 − 0.4) ∗ 5, 000, 000 =
3, 000, 000 at the option expiry date. The present value of the payment is
approximately 3, 000, 000 ∗ exp(−4% ∗ 0.25) ≈ 2, 970, 000 . At the same
time the option holder makes a mark-to-market loss of approximately
(200 − 100)/10000 ∗ 4.15 ∗ 5, 000, 000 = 207, 500 on the remaining CD
index swap. The total value to the option holder would be 2, 762, 500 in
this case. If both names default then the value to the option holder would
be even greater. Suppose defaults between the two reference names are
independent of each other. The probability of having at least one default is
1 − (1 − 0.42%)2 ≈ 0.838% . Therefore, the expected value to the option
holder would be slightly greater than 2, 762, 500 ∗ 0.838% ≈ 23, 150 .
However, the swaption price given by (32) is approximately 260 if the log-
normal volatility of the default-adjusted forward CD index swap rate is
assumed to be σ = 50% . To have the option price given by (32) exceed
23, 150 , a lognormal volatility of over 120% is needed. By contrast, we are
able to generate an option price of 23, 500 by using (19), (25) and (29) with
a lognormal volatility of 50% and zero correlation. A higher correlation
generates a slightly higher option value. For example, the option value
obtained from (19), (25) and (29) is 24, 300 when the correlation is 90% .
Because the option value in this case is dominated by the value of the
expected loss which is approximately 25, 000 , it is hardly surprising to see
that the option value is almost insensitive to correlation.
Wilmott magazine
TECHNICAL ARTICLE 6
FOOTNOTES & REFERENCES
1. If the coupon is paid on the notional remaining at the coupon date, i.e.,
contingent
 accrued coupon is not paid, then the annuity reduces to
Ā(t) = ni=1 δi D(t, ti )(1 − p(t, ti )) .
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97