Pricing CDOs with a Smile: The Local Correlation Model

Turc, Julien; Véry, Philippe

doi:10.1002/9781118266915.ch9

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If You Want To Know the Value Of A Security Use The Price O1

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“…Given some stated dependence between correlation and credit spreads, one can compute the total derivative of a CDO tranche with respect to a shift in credit spreads. For instance, using the moneyness matching approach in Turc et al (2006), an increase in credit spreads is associated with an increase in the expected loss and thus a decrease in the detachment point of the "equivalent" equity tranche. Since base correlations curves are usually upward sloping, an increase in credit spreads is thus associated with a decrease in base correlations.…”

Section: If You Want To Know the Value Of A Security Use The Price Omentioning

confidence: 99%

Dynamic Hedging of Synthetic CDO Tranches: Bridging the Gap between Theory and Practice

Cousin¹,

Laurent

2011

Credit Risk Frontiers

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Section: If You Want To Know the Value Of A Security Use The Price Omentioning

confidence: 99%

Dynamic Hedging of Synthetic CDO Tranches: Bridging the Gap between Theory and Practice

Cousin¹,

Laurent

2011

Credit Risk Frontiers

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State dependent correlations in the Vasicek default model

Metzler

2020

Dependence Modeling

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This paper incorporates state dependent correlations (those that vary systematically with the state of the economy) into the Vasicek default model. Other approaches to randomizing correlation in the Vasicek model have either assumed that correlation is independent of the systematic risk factor (zero state dependence) or is an explicit function of the systematic risk factor (perfect state dependence). By contrast, our approach allows for an arbitrary degree of state dependence and includes both zero and perfect state dependence as special cases. This is accomplished by expressing the factor loading as a function of an auxiliary (Gaussian) variable that is correlated with the systematic risk factor. Using Federal Reserve data on delinquency rates we use maximum likelihood to estimate the parameters of the model, and find the empirical degree of state dependence to be quite high (but generally not perfect). We also find that randomizing correlation, without allowing for state dependence, does not improve the empirical performance of the Vasicek model.

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Pricing CDOs with a Smile: The Local Correlation Model

Cited by 2 publications

References 2 publications

Dynamic Hedging of Synthetic CDO Tranches: Bridging the Gap between Theory and Practice

Dynamic Hedging of Synthetic CDO Tranches: Bridging the Gap between Theory and Practice

State dependent correlations in the Vasicek default model

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