This paper drives a pricing formula for a default swap
option (DSO) that an investment bank in Japan produced on
the credit-risk of a convertible bond (CB) issued by a third
company C. In this DSO contract, a protection buyer A not
only obtains a full hedge for the principal of the CB against
a default of C but also owns the option of starting an interest
swap between the buyer and a protection seller B when a credit
event happens. This option gives A an opportunity to recover
the interests from the CB as well. When A starts the swap
after a default, the floating rate is associated with the
protection premium. After a certain simplification, this paper
makes a no-arbitrage valuation for the premium in a discrete
time approach. In addition, when the credit quality of the
parties A and B is taken into account in the valuation, a
fair value of the default swap option is also derived.
