Nº 20-88: Credit Volatility Indexes

This paper contains details for implementing credit spread variance pricing methodologies based on credit default swap (CDS) options. A model independent formula for expected volatility is available, based on the prices of vanilla CDS options (VCOs). However, VCOs are currently not traded, and their prices must be inferred from those of actively traded CDS options with exotic payoffs (ECOs). Plugging ECO prices directly into the index formula is not theoretically justified, and the economic significance in the context of variance pricing of the difference in options contract specifications must be examined empirically. The paper develops methodology for converting observed ECO prices into hypothetical VCO prices for the purpose of index calculation, and assesses the economic impact of using ECOs and VCOs on index values under realistic market conditions.