Pricing Credit Spread Option Based On The Term Structure

As the market-oriented reforms of interest rate have been progressing steadily in China, the competition from financial market would be fiercer. In allusion to the risk management and financial innovation issues of banks and other financial institutions. We conduct a research work on credit spread option, which is the most sensitive one to the change of interest rate among credit derivatives. The main contents and innovations of this paper are as follows:1. We investigate the mean-reversion and volatile of credit spread time series by using regression analysis and time series analysis in Chinese bond market.2. We present a method of pricing credit spread option on the basis of three factors affine term structure model of interest rates with Kalman filter and Monte Carlo simulation. In this way, the term structures of the Aaa corporate bonds and the Treasury debts with the same maturities in interbank market of China are obtained. Then the credit spreads of corporate bonds are obtained. So European credit spread put option can be priced according to the definition of pricing option. The correlations of option price and strike spread, option expiration are considered. The results show that the prices of the credit spread put option increase when the strike spreads decrease. The market prices of corporate bonds have a negative correlation with the market spreads. Due to different option expirations, the prices of corporate bonds will be distinct, and so will be the credit spread option prices.3. The Longstaff-Schwartz model and GARCH model are applied to price credit spread put option. We compare the features of these two models by employing daily bond prices of government bonds and corporate bonds during the period2010-2012in Chinese bond market. Our results show that the higher the credit ratings of the corporate bonds are, the lower the prices of the credit spread options are. Moreover, it is also found that the prices of option roughly become higher as the maturities of bonds decreasing.