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Consistent Valuation of Bespoke CDO Tranches

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  • Yadong Li

Abstract

This paper describes a consistent and arbitrage-free pricing methodology for bespoke CDO tranches. The proposed method is a multi-factor extension to the (Li 2009) model, and it is free of the known flaws in the current standard pricing method of base correlation mapping. This method assigns a distinct market factor to each liquid credit index and models the correlation between these market factors explicitly. A low-dimensional semi-analytical Monte Carlo is shown to be very efficient in computing the PVs and risks of bespoke tranches. Numerical examples show that resulting bespoke tranche prices are generally in line with the current standard method of base correlation with TLP mapping. Practical issues such as model deltas and quanto adjustment are also discussed as numerical examples.

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  • Yadong Li, 2010. "Consistent Valuation of Bespoke CDO Tranches," Papers 1004.1758, arXiv.org.
    • Handle: RePEc:arx:papers:1004.1758
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    References listed on IDEAS

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    1. Friedel Epple & Sam Morgan & Lutz Schloegl, 2007. "Joint Distributions Of Portfolio Losses And Exotic Portfolio Products," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 733-748.
    2. Igor Halperin, 2009. "Implied Multi-Factor Model for Bespoke CDO Tranches and other Portfolio Credit Derivatives," Papers 0910.2696, arXiv.org.
    3. Li, Yadong, 2009. "A Dynamic Correlation Modelling Framework with Consistent Stochastic Recovery," MPRA Paper 14919, University Library of Munich, Germany, revised 02 Apr 2009.
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