《Okane and Turnbull》.pdf

Fixed Income Quantitative Credit Research April 2003 Valuation of Credit Default Swaps Dominic O’Kane and Stuart Turnbull Marking default swap positions to market requires a model. We present and discuss the model most widely used in the market. Lehman Brothers | Quantitative Credit Research April 2003 Valuation of Credit Default Swaps Dominic O’Kane We present the market standard pricing model for marking credit default swap +44 (0) 20 7260 2628 positions to market. Our aim is first to explain why credit default swaps require a dokane@ valuation model, and then to explain the standard model – the one most widely used in the market. In the process of setting out the model, we take care to explain and Stuart Turnbull justify the various modeling assumptions made. We also provide examples. +1 212 526 9251 sturnbul@ 1 INTRODUCTION 1 The credit default swap is a simple derivative contract that has revolutionized the trading of credit risk. Over the past five years it has become the most widely used credit derivative product, representing about 72.5% of a total outstanding market notional currently estimated to be around $2.3 trillion2 . The default swap market is truly global, with contracts linked to the credit risk of a wide array of US, European and Asian corporate names as well as to a number of sovereig