Index Credit Default Swap Option

ORE defines the product as follows:

An index CDS option, trade type IndexCreditDefaultSwapOption, is an option to enter into an index CDS at a specified strike spread or strike price.

Source: ORE User Guide, Products catalogue, indexcdsoption.tex.

An index CDS option is an option on insurance premia. The buyer pays a premium for the right to buy or sell index protection later at a rate set today. If the market moves in the buyer's favour, the option is exercised. Otherwise it expires worthless.

The trade data names the underlying index CDS and the option terms. The OptionData node holds the usual option mechanics, long or short, exercise style, and settlement. The Strike and StrikeType set the level, as a spread or as a price. The underlying IndexCreditDefaultSwapData node describes the index CDS that the exercise starts.

The IndexTerm node gives the term of the underlying index CDS, such as 5Y or 10Y. ORE uses it to find the right volatility surface. With no IndexTerm, the market is searched for a surface named after the credit curve of the index series. With one, the surface name carries a suffix such as CDXHYS34V1-5Y. Different terms of one series can then use different volatility structures.

ORE describes the credit mechanics as follows:

CDS Options can come with or without front end protection, i.e. the protection seller may either have to pay the contract notional if default happens before option expiry, or not (knock out).

Source: ORE User Guide, Products catalogue, indexcdsoption.tex.

An option on an index CDS prices off a CDS volatility surface. At expiry, the option is worth the difference between the market protection value and the strike protection value. Options on credit indices include any defaulted entities in the intrinsic value when exercised, per ORE's payoff description. Options on single credits are extinguished upon default without cash flows other than the upfront premium.

• The CDS volatility surface of the index term. It drives the option value.
• The index credit curve. It sets the level of the underlying protection.
• The strike spread or price. It fixes the exercise terms.
• The discount curve of the premium currency.
• The composition of the index and its defaults before expiry.

A payer of protection gains when the index worsens. A receiver gains when it improves. Volatility raises the value of both sides.

The option loses time value as expiry approaches. A default in the index before expiry settles through the front-end protection terms, or knocks the option out. At expiry, a European option exercises into the index CDS or expires. After exercise, the trade ages like the underlying Index Credit Default Swap.

A bank buys index CDS options to cap the cost of future protection. A dealer sells them to earn the option premium and to express views on credit volatility. The product hedges spread moves without committing to the running premium. In ORE Studio a customer books index CDS options to value them and run sensitivities on the ORE engine.

ORE's catalogue shows a long European option on a 5Y index:

<IndexCreditDefaultSwapOptionData>
  <IndexTerm>5Y</IndexTerm>
  <OptionData>
    <LongShort>Long</LongShort>
    <Style>European</Style>
    <Settlement>Cash</Settlement>
    <PayOffAtExpiry>false</PayOffAtExpiry>
    <ExerciseDates>
      <ExerciseDate>2023-05-09</ExerciseDate>
    </ExerciseDates>
  </OptionData>
  <IndexCreditDefaultSwapData>
    ...
  </IndexCreditDefaultSwapData>
  <Strike>1.063</Strike>
  <StrikeType>Price</StrikeType>
</IndexCreditDefaultSwapOptionData>

Source: ORE User Guide, Products catalogue, indexcdsoption.tex, listing IndexCreditDefaultSwapOption Data (underlying abbreviated).