Pricing CDS Index Options in a Nonlinear Filtering Model
Dr. Alexander Herbertsson
Department of Economics
University of Gothenberg, Sweden
We derive practical formulas for forward starting index CDS spreads in the filtering model of Frey and Schmidt (2009). We also outline a novel approach for estimating the parameters in the filtering models by using time-series data of index CDS spreads and classical maximum-likelihood algorithms. The calibration-approach incorporates the Kushner-Stratonovich SDE for the dynamics of the filtering probabilities. The convenient formula for the forward starting index-CDS is a prerequisite for our estimation algorithm. Furthermore, a systematic study is performed in order to understand the impact of various model parameters on credit index options (and on the index itself).