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Dear all; Currently I need to develop a model for pricing credit range accrual which is based on the credit spread of iTRAXX. Do you guys have any paper for pricing this product or related to model the credit spread of iTRaxx?Lookin gforward to your help!Thanks.LJ

Hi ljcao, I'm trying to do this aswell.The main problem is "What happens to the spread when a default occurs?". We otherwise could fit some arbitrary dynamics to the credit index spread and option prices. Unfortunately, if the spread were not expected to change when default happens, then the skew on the option prices would be much greater than is seen in the market.If we set some arbitrary dynamics to the spread (or the equivalent short-rate), we can fit the model to the loss dynamics of the portfolio. See Schonbucher's paper on modelling loss transitions in a HJM style framework or the (similar) SPA model of Sidenius, Piterbarg and Anderson. However, much work is still needed to fit the model to the index and tranche spreads... never mind the index or tranche vols.Alternatively, we can try to model the individual names within the index - either in a copula or in a factor based approach. See the Markov chain model of Graziano and Rogers. This looks quite promising but there are no promises that it is possible to fit this to the index option prices (which you'd use for hedging).Perhaps the simplest approach is to create a model which is only calibrated to the index - not the tranche rates - and with an externally prescribed change in the spread upon default which can be used to hit the market option prices.You won't be fitting the model to the tranche spreads but the market isn't sophisticated enough to arbitrage index vol skew with equity tranche products yet... there just isn't the completeness required for that.Anybody else got any ideas on this?

Once you can price european options on iTraxx, you can then price binaries. A range accrual is a simple sum of binaries, with deferred payout.You will find credit index options are illiquid and normally are only quoted out a few months.What I find interesting is how people price 10 year versions of these things!

QuoteOriginally posted by: erstwhileOnce you can price european options on iTraxx, you can then price binaries. A range accrual is a simple sum of binaries, with deferred payout.You will find credit index options are illiquid and normally are only quoted out a few months.What I find interesting is how people price 10 year versions of these things!Where ya been?

Erstwhile, that's not correct. The payout for a CDS index option includes default payout prior to exercise date... and the deliverable (the CDS) has default risk on the notional. The range accrual does not include default prior to exercise and often has a non-risky notional. Therefore, European options (even binaries if you could get them) on ITRAXX do not comprise a good hedge to the range accrual.It is NOT a simple sum of binaries...Oh, and they're not illiquid on CDX XOver index either - you can get a good range of options out to 1 year - which is about the maturity most people are quoting range-accruals to.