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DYNAMIC CREDIT CORRELATION MODELING C. ALBANESE, O. CHEN, A. DALESSANDRO, AND A. VIDLER
 

Summary: DYNAMIC CREDIT CORRELATION MODELING
C. ALBANESE, O. CHEN, A. DALESSANDRO, AND A. VIDLER
Abstract. As the market for credit baskets and single tranche bespoke CDOs
keeps growing very rapidly, we witness a lively debate about the merits and
shortcomings of the base correlation model, which is currently the recognized
market standard. Difficulties such as the lack of arbitrage-freedom and the
witnessed impossibility to calibrate in some market situations are motivations
to research a different standard for mark-to-market and risk management. To
contribute to this ongoing debate, we describe here a new modeling framework
based on a structural, bottom-up approach. Points of interest for this model
are that it can be made consistent with many data sources such as rating tran-
sition probabilities, historical default probabilities, single name credit spread
curves and equilibrium recovery swap rates. Remarkably enough, we find that
the model can be calibrated simultaneously to synchronous datasets for the
iTraxx and CDX term structures for tranche spreads across the entire capital
structures, including the index basis, and for maturities up to 10 years. The
model makes use of an innovative mathematical framework based on spectral
analysis and provides numerically noiseless spreads and hedge ratios. As far as
execution times are concerned, the model is at least as fast if not faster than
the most simplified analytic versions of the base correlation model.

  

Source: Albanese, Claudio - Department of Mathematics, King's College London

 

Collections: Mathematics