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Pricing Synthetic CDOs Using a Three Regime Random-Factor-Loading Model

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  • Messow, Philip

Abstract

Synthetic Collateralized Debt Obligations (CDOs) were among the driving forces of the rapid growth of the market for credit derivatives in recent years. Possibly the most popular model beside the Gaussian copula for pricing CDO tranches is the Random-Factor-Loading-Model of Andersen and Sidenius (2005). We extend this model by allowing more than two regimes of default correlations. The model is calibrated to market spreads at times of financial distress and during calm periods. For both points in time the model correlation skews are similar to the steep skews observed in the market and lead to an improvement to the standard Random-Factor-Loading-Model.

Suggested Citation

  • Messow, Philip, 2012. "Pricing Synthetic CDOs Using a Three Regime Random-Factor-Loading Model," Ruhr Economic Papers 317, RWI - Leibniz-Institut für Wirtschaftsforschung, Ruhr-University Bochum, TU Dortmund University, University of Duisburg-Essen.
    • Handle: RePEc:zbw:rwirep:317
    DOI: 10.4419/86788366
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    References listed on IDEAS

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    1. 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.
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    4. Glasserman, Paul & Suchintabandid, Sira, 2007. "Correlation expansions for CDO pricing," Journal of Banking & Finance, Elsevier, vol. 31(5), pages 1375-1398, May.
    5. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2007. "Selecting copulas for risk management," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2405-2423, August.
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    More about this item

    Keywords

    Collateralized debt obligation; random-factor-loading; pricing; financial dependence; factor model; default risk; correlated defaults;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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