Forums > Pricing & Modelling > option on forward cds

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 hhb Total Posts: 7 Joined: Sep 2015
 Posted: 2017-07-14 21:02 Any hints/documents on how to value option on forward starting cds
 hhb Total Posts: 7 Joined: Sep 2015
 Posted: 2017-07-15 21:00 Hi All,Any suggestions regarding this. Urgently need this.
 ronin Total Posts: 230 Joined: May 2006
 Posted: 2017-07-19 14:55 What does the option look like? Option matures in one year, CDS protection starts in two years, ends in five years?You can't replicate that from CDS swaptions and outrights. The closest you can come is say 1y5y swaption minus 1y2y swaption plus forward adjustment plus fudge factor. "People say nothing's impossible, but I do nothing every day" --Winnie The Pooh
 hhb Total Posts: 7 Joined: Sep 2015
 Posted: 2017-07-23 14:01 Thanks Ronin for response. Yes, that is the form of option. What is "forward adjustment plus fudge factor"? Any way to calculate those.
 ronin Total Posts: 230 Joined: May 2006
 Posted: 2017-07-25 10:49 If you started hedging your 1y option on the 2y5y cds with a 1y5y swaption, you have to worry about two things:(i) the contribution of the 1y2y period to the forward (which is in the hedging instrument, but not in your product)(ii) the variance of the 1y2y contribution to the forward (which is again in the hedging instrument, but not in the product).So my suggestion was to use the 1y2y swaption to extinguish the contribution to variance. The ratio that you used to extinguish the variance won't be the same as the ratio that you need to extinguish the forward. So you then have to adjust to the right forward. Then, you are still left with a static replication for something that can not be statically replicated. So you need a "fudge factor" to account for any cost of dynamic hedging.Alternatively, just calibrate some Hull-White model to cds swaptions and run Monte Carlo on your payoff. "People say nothing's impossible, but I do nothing every day" --Winnie The Pooh
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