Local Volatility and the Recovery Rate of Credit Default Swaps
Jeroen Jansena, Sanjiv Dasb, and Frank J. Fabozzi
Credit default swap (CDS) spreads can only be decomposed into the probability of default and the loss-given-default by imposing some structure. Employinga hybrid binomial tree for equities and a recovery function, Das and Hanouna (2009)obtainaccurate estimates for CDS spreadsby fitting the model to historical equity volatilities. We extend their approach by including the full implied volatility surface,developingan implied binomial tree with a jump to default based on extending the Derman and Kani (1994)tree. We then evaluate the effect of including the full volatility surface on the implied CDS recovery rate.