Valuation of Credit Contingent Claims: An Arbitrage-Free Credit Model

Thomas S. Y. Ho and Sang Bin Lee

Volume 7, Number 3, Third Quarter 2009

This study extends the generalized Ho-Lee model to the credit derivative swap (CDS) curve movements that ensures the hazard rate movement is arbitrage-free for any given CDS curve. This study shows that the generalized Ho-Lee model is not limited to pricing the interest contingent claims. The Ho-Lee model can be equally applicable to pricing the credit contingent claims. This model can value a broad range of credit contingent claims. These credit contingent claims include the American and the Bermudan CDS options, make-whole and callable bonds. This model features the separation of the specification of volatilities of the hazard rate from the fitting of the model to the CDS curve. Our model has several advantages over other models because of this separation feature. For example, we can use the model to depict the credit performance profile of a bond, by plotting the credit contingent claim values over a range of hazard curves. The performance profiles can identify the impact of the credit risks on the contingent claims.