CDS index options in Markov chain models

We study CDS index options in a credit risk model where default times have intensities which are driven by a finite-state Markov chain representing the underlying economy. In this setting, we derive computational tractable... [ view full abstract ]

We study CDS index options in a credit risk model where default times have intensities which are driven by a finite-state Markov chain representing the underlying economy. In this setting, we derive computational tractable formulas for the price of a CDS index option. In particular, the evaluation of the CDS index option is handled by translating the Cox-framework into a bivariate Markov chain. Under same exogenous circumstances, we give numerical examples showing that CDS index options prices in the Markovian model can be several hundred percent bigger compared with models assuming that the CDS index spreads follows a log-normal process.