Credit Option Valuation

Hi everyone,

I am seeking your advise with Credit Option valuation. I have a couple of ideas but I’m not sure that they are really good suitable.

I am really appreciate your advise with this case.

The main terms of the trade are:

There are 3 companies A, B and C.

Company A (lender) provide a loan to Company C.

Company B writes an option to Company A: if the Company C will go to bankruptcy the Company B will become a lender.

So the strike is the default event, and the underlying is the right of the Company A to transfer the “bad” loan to Company B.

What is a good way to calculate a premium for such option?

Thank you in advance for your help.

Value the option as a factor of the CDS spread on company C multiplied by the loan amount.

For example; the 5yrs CDS on company C is 220bps, the loan amount is £100. Therefore, to insure the bankruptcy of company C, a lender will have pay £2.20 per annum. If there is a default, the CDS seller has to pay the company A £100.

This doesn’t take into account recovery value etc i.e. what is the loss on the loan in bankruptcy?

You could say that recovery is £10, therefore you’re only willing to pay 220bps on the £90 - therefore you’re willing to £1.98pa.

lemme know if this helps…

Hi, thanks a lot for sharing your ideas. It is really helpful.

I think the same way. Considering, the company C is not tradable and there is no CDS on C, I assume to identify the company C credit rating, then to find CDS on similar companies and calculate ranges for such CDS spreads.

that probably serves as a reasonable proxy.