No-arbitrage approach to pricing credit spread derivatives

No arbitrage in the case of pricing credit spread derivatives refers to determination of the time-dependent drift terms in the mean reversion stochastic processes of the instantaneous spot rate and spot spread by fitting the current term structures of default-free and defaultable bond prices. The riskless rate and the credit spread of a reference entity are taken to be correlated stochastic state variables in this pricing model. When the spot rate and spot spread both follow the Hull and White model, one can derive an analytic representation for the time-dependent drift terms and analytic price formulas for credit spread options. Algorithms for the numerical valuation of credit spread derivatives are developed, and the pricing behaviors of credit spread options are examined.