Credit Default Swap Options
A credit default swap option is also known as a credit default swaption. It is an option on a credit default swap (CDS). A CDS option gives its holder the right, but not the obligation, to buy (call) or sell (put) protection on a specified reference entity for a specified future time period for a certain spread. The option is knocked out if the reference entity defaults during the life of the option. This knock-out feature marks the fundamental difference between a CDS option and a vanilla option. Most commonly traded CDS options are European style options.
Similar to the credit default swaps, there are varieties of CDS options:
- CDS options on a single entity with a regular payoff for the default leg;
- CDS options on a single entity with a binary payoff for the default leg;
- CDS options on a basket of entities with regular payoff for the default leg;
- CDS options on a basket of entities with a binary payoff for the default leg.
Generally, the default probability curve and the recovery rate of a reference entity are the most important factors that affect the value of a CDS option. If a CDS option has a basket of reference entities, the default correlations of the reference entities are also important factors that affect the value of a CDS option. CDS values can also be affected significantly by the types of basket defaults. Currently, the most common types of basket defaults are the first-to-default, the n-th-to-default, the first-n-to-default, and all-to-default.
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