Problems & Solutions

1. Bootstrapping Default Probability Curves What are the different methods for bootstrapping default probability curves?Currently, there are three different methods for bootstrapping default probability curves from par credit default swap spreads. These involve (1) assuming that the default densities are constant between consecutive maturities of given credit default swaps (CDSs); (2) assuming that the default intensities are constant between consecutive CDS maturities; and (3) assuming that the par CDS spread of any maturity can be interpolated from the given CDS spread curve. Given the three possible assumptions, does one recover the original par CDS spread when the different bootstrapped default probability curves are used to value the original CDS? Editor's note: Lawrence Luo will discuss some methodologies associated with this topic in the Credit Risk Forum section in the next issue. 2. Base Correlations for Synthetic CDOs In spite of major developments in the collateralized debt obligations (CDO) market, a coherent measure of correlation used for comparing prices amongst different tranches is still wanting. What are base correlations and what is their role in the relative valuation of CDO tranches? How do base correlations behave under changing behavior of default correlations? Are there potential problems in using base correlations as a quotation device and a relative valuation too? Editor's note: In the next issue Soren Willemann will provide answers to these questions in the Credit Risk Forum section.