Credit Spread Option Pricing by Dynamic Copulas

Abstract

This paper extends the dynamic copula model for bivariate option pricing in Goorbergh et al (2004) to price credit spread options. We use GARCH-t model to describe the marginal distributions for corporate bonds and treasury, and combine them with dynamic Gaussian copula to obtain the joint distribution. As an application we use this model to price credit spread options written on American corporate bonds. Unlike other approaches for credit spread option pricing, this model is based on the two components of the spread rather than the spread itself, and the dependence structure is time-varying.