A measure of survival
Given the improving liquidity of the plain vanilla credit default swap (CDS) markets, derivatives on CDSs – in particular options on CDSs – are increasing in volume. Philipp Schönbucher shows how such options can be priced using defaultable assets as numeraires. He derives various option pricing formulas for different volatility specifications, including a modified version of the famous Black (1976) formula. Using CDS market data he then finds that lognormal volatilities are a more appropriate description of CDS volatilities than Gaussian or square-root volatilities.
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