Fast Valuation of Forward-Starting Basket Default Swaps

A basket default swap (BDS) is a credit derivative with contingent payments that are triggered by a combination of default events of the reference entities. A forwardstarting basket default swap (FBDS) is a BDS starting at a specified future time. Existing analytic or semi-analytic methods for pricing FBDS are time consuming due to the large number of possible default combinations before the BDS starts. This paper develops a fast approximation method for FBDS based on the conditional independence framework. The method converts the pricing of a FBDS to an equivalent BDS pricing problem and combines Monte Carlo simulation with an analytic approach to achieve an effective method. This hybrid method is a novel technique which can be viewed either as a means to accelerate the convergence of Monte Carlo simulation or as a way to estimate parameters in an analytic method that are difficult to compute directly. Numerical results demonstrate the accuracy and efficiency of the proposed hybrid method. This research was supported in parted by the Natural Sciences and Engineering Research Council (NSERC) of Canada. Department of Computer Science, University of Toronto, 10 King’s College Road, Toronto, ON, M5S 3G4, Canada; [email protected] Algorithmics Inc., 185 Spadina Avenue, Toronto, ON, M5T 2C6, Canada; [email protected] Department of Computer Science, University of Toronto, 10 King’s College Road, Toronto, ON, M5S 3G4, Canada; [email protected]