Journal of Credit Risk

Risk.net

Credit default swap trees

Ridha Mahfoudhi

ABSTRACT

The credit default swap (CDS) market has gained in importance and popularity by being adapted to the sophisticated hedging and investment strategies of investors acting in the credit market. The development of sound and flexible models that can be easily calibrated to market data and that can allow the valuation of the growing family of CDS derivatives has never been as important and timely as it is in the current market environment. This paper responds to these needs by providing an arbitrage-free tree approach of dynamic mean-reverting leverage that allows perfect matching of the market CDS curve while also offering robust calibration to market volatility data. The proposed CDS-tree model simplifies and unifies the valuation of both plain-vanilla and complex CDS derivatives, including European-style options, Bermudan CDS options and constant maturity CDSs.

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