Credit Risk Derivatives

Abstract

This article models the pricing of derivatives on credit risk, instruments proposed in 1992 by the International Swap Dealers Association that have started attracting market attention. The exact structure of the instruments continues to evolve today.We develop a framework to understand the key features of this class of products. It is shown that the price of the credit risk option is the expected forward value of a put option on a risky bond with a credit level-adjusted exercise price. Stripping of credit risk from the total risk of the bond is enabled by employing a stochastic strike price for the credit risk option. The article provides a framework for trading and hedging credit risk.

JEL Classification: G13