Trading in the Credit Derivatives market with equity-based Credit Default Swap spreads

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: This thesis gives an introduction to BASEL II and hence a motivation for the use of credit derivatives in general and Credit Default Swaps in particular. We develope (from Atlan and Leblanc (2005) and Bengtsson and Bjurhult (2006)) a model to price the CDS contracts and use this in a trading strategy - trying to find risk arbitrage. The probability of default (PD), used in the pricing model, is derived from the stopped (i.e. the model stops as the stock price reaches 0) Constant Elasticity of Variance (CEV ) model and uses only the equity price for the corresponding company as input. From the equity price, historical volatility is estimated and also used in the model. Available data is CDS spreads (for calibration) and equity price (for calibration and also prediction of CDS spreads). A simple trading strategy is adopted. This is because we only want an indication of the qualitative properties of the model. The results from the trading are good, showing profit in 8 out of 9 companies.

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