Binomial Approximation to Locally Dependent CDO

Abstract

In this paper, we develop Stein's method for binomial approximation using the stop-loss metric that allows one to obtain a bound on the error term between the expectation of call functions. We obtain the results for a locally dependent collateralized debt obligation (CDO), under certain conditions on moments. The results are also exemplified for an independent CDO. Finally, it is shown that our bounds are sharper than the existing bounds.