Understanding the Default-Implied Volatility for Credit Spreads

Abstract

One useful way to model default risk in bonds is as a form of option within the contingent claims framework. Zheng shows how a defaultable bond can be thought of as a combination of a default-free bond and a short position in a certain kind of barrier option. In that case, it is possible to compute an implied volatility of the default spread from the (implied) price of that option. With such a volatility estimate, one can price credit derivatives using the market's implied credit spread volatility. Zheng illustrates the approach by computing an implied volatility curve and applying it to value a credit spread put and a first-to-default swap.