Dynamic alpha-stable method for CDO pricing

Hua Li (), George Yuan (), Weina Chen (), Li Guo () and Jianbin Zhao ()
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Hua Li: School of Mathematics and Statistics, Zhengzhou University, Henan 450001, China
George Yuan: Institute of Risk Management, Department of Mathematics, Tongji University, Shanghai 200092, China
Weina Chen: School of Mathematics and Statistics, Zhengzhou University, Henan 450001, China
Li Guo: School of Mathematics and Statistics, Zhengzhou University, Henan 450001, China
Jianbin Zhao: School of Mathematics and Statistics, Zhengzhou University, Henan 450001, China

Journal of Financial Engineering (JFE), 2014, vol. 01, issue 03, 1-16

Abstract: The goal of this paper is to develop the dynamic alpha (α)-stable method for collateralized debt obligation (CDO) pricing based on the α-stable distributions, which will resolve the two issues caused by using traditional static factor copula method in the practice, which means when pricing CDOs, the traditional static factor Copula method does not only exhibit the correlation smile phenomenon which is not inconsistent with the model's assumption, but also cannot be used in pricing CDOs or credit portfolio derivatives for the underlying portfolio with different maturities. As the applications, we present calibration and empirical numerical results for iTraxx Europe Tranches quotes from the market data on March 30, 2007. Thus, our new method under the framework of the dynamic α-stable model is the way for CDO pricing in the practice, and should be useful for the risk management in the practice too.

Keywords: CDO pricing; dynamic copula; alpha (α)-stable distribution; chaining method; correlation smile (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S2345768614500287

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