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On break-even correlation: the way to price structured credit derivatives by replication

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  • Jean-David Fermanian

    (CREST-ENSAE)

  • Olivier Vigneron

    (JP-Morgan)

Abstract

We consider the pricing of European-style structured credit payoff in a static framework, where the underlying default times are independent given a common factor. A practical application would consist of the pricing of nth-to-default baskets under the Gaussian copula model (GCM). We provide necessary and sufficient conditions so that the corresponding asset prices are martingales and introduce the concept of "break-even" correlation matrix. When no sudden jump-to-default events occur, we show that the perfect replication of these payoffs under the GCM is obtained if and only if the underlying single name credit spreads follow a particular family of dynamics. We calculate the corresponding break-even correlations and we exhibit a class of Merton-style models that are consistent with this result. We explain why the GCM does not have a lot of competitors among the class of one-period static models, except perhaps the Clayton copula.

Suggested Citation

  • Jean-David Fermanian & Olivier Vigneron, 2012. "On break-even correlation: the way to price structured credit derivatives by replication," Papers 1204.2251, arXiv.org.
    • Handle: RePEc:arx:papers:1204.2251
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    References listed on IDEAS

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    1. Jean-Paul Laurent & Jon Gregory, 2005. "Basket default swaps, CDOs and factor copulas," Post-Print hal-03679517, HAL.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. Damiano Brigo & Aurélien Alfonsi, 2005. "Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model," Finance and Stochastics, Springer, vol. 9(1), pages 29-42, January.
    4. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
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