Credit Derivatives and Structured Credit: A Guide for Investors

6

Pricing Models for Credit Derivatives

The development of derivative markets in the last decades has been closely linked to the development of mathematical models for pricing and hedging derivative instruments. Not surprisingly, the growth in credit derivatives has generated a considerable literature on the modeling, pricing and hedging of these products. Conversely, much of the innovation in the credit derivatives market would not have been possible without the existence of quantitative approaches to credit risk. As a result of the availability of quantitative pricing models, the credit derivatives market has become increasingly sophisticated, issuing complex multi-name and hybrid credit derivatives, such as those described in Chapters 3 and 4.

The approach of market operators to the pricing of credit-sensitive products is to avoid using model-based pricing criteria whenever possible. The pricing of cash credit products – bank loans in particular – is based on market demand and supply and, in this respect, is more like the cash equity market than the options market. With the steady increase of liquidity in the CDS market, these products have become mainstream ‘vanilla’ instruments, with market prices driven by supply and demand. However, for more complex over-the-counter credit derivatives and for correlation products such as first-to-default swaps or CDO tranches, pricing cannot be done in a model-free way and quantitative modeling is thus unavoidable.

Quantitative models of ...