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A comparative analysis of correlation skew modeling techniques for CDO index tranches

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  • Claudio, Ferrarese

Abstract

In this work we present an analysis of CDO pricing models with a focus on “correlation skew models”. These models are extensions of the classic single factor Gaussian copula and may generate a skew. We consider examples with fat tailed distributions, stochastic and local correlation which generally provide a closer fit to market quotes. We present an additional variation of the stochastic correlation framework using normal inverse Gaussian distributions. The numerical analysis is carried out using a large homogeneous portfolio approximation.

Suggested Citation

  • Claudio, Ferrarese, 2006. "A comparative analysis of correlation skew modeling techniques for CDO index tranches," MPRA Paper 1668, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:1668
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    File URL: https://mpra.ub.uni-muenchen.de/1668/1/MPRA_paper_1668.pdf
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    References listed on IDEAS

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    2. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    3. Leland, Hayne E & Toft, Klaus Bjerre, 1996. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
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    6. Andrew Friend & Ebbe Rogge, 2005. "Correlation at First Sight," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 34(2), pages 155-183, July.
    7. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
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    More about this item

    Keywords

    default risks; CDOs; index tranches; factor model; copula; correlation skew; stochastic correlation;
    All these keywords.

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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