Abstract
Credit derivatives were arguably invented by Bankers Trust (now part of Deutsche Bank) in 1991, with the product market not taking off until 1996 due to a period of tight credit spreads and generally favorable credit market conditions witnessed during the first half of the 1990s. Product education, advances in pricing, and more adverse credit events during the last decade have served to accelerate market growth. Indeed, the credit derivatives market is widely regarded as the fastest growing sector of the derivatives industry and now exhibits over $5 trillion in average outstanding notional principal worldwide. Credit default swaps (CDSs) account for approximately 72.5% of the marketplace, with the remaining 27.5% spread mostly across credit spread swaps, total rate of return swaps, and credit spread options. Options on credit default swaps – known as CDS swaptions – have only recently become popular among end users. CDS swaptions come in two general varieties: Calls and puts written on CDSs, and cancelable CDSs. A cancelable CDS contains an embedded option to terminate an existing CDS (an embedded CDS swaption). This paper describes credit default swaptions, provides illustrations of their uses, for example, in creating synthetic collateralized debt obligations, and presents and illustrates valuation models. The pricing models offered here are more accessible than those presented in the working papers of Sch􀁀nbucher (2000), Jamshidian (2002) and Schmidt (2004).