Correlation smile matching for collateralized debt obligation tranches with α-stable distributions and fitted Archimedean copula models

Dirk Prange and Wolfgang Scherer

Quantitative Finance, 2009, vol. 9, issue 4, 439-449

Abstract: As an extension of the standard Gaussian copula model to price collateralized debt obligation (CDO) tranche swaps we present a generalization of a one-factor copula model based on stable distributions. For special parameter values these distributions coincide with Gaussian or Cauchy distributions, but changing the parameters allows a continuous deformation away from the Gaussian copula. All these factor copulas are embedded in a framework of stochastic correlations. We furthermore generalize the linear dependence in the usual factor approach to a more general Archimedean copula dependence between the individual trigger variable and the common latent factor. Our analysis is carried out on a non-homogeneous correlation structure of the underlying portfolio. CDO tranche market premia, even throughout the correlation crisis in May 2005, can be reproduced by certain models. From a numerical perspective, all these models are simple, since calculations can be reduced to one-dimensional numerical integrals.

Keywords: Copulas; Correlation modelling; Credit derivatives; Credit models (search for similar items in EconPapers)
Date: 2009
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DOI: 10.1080/14697680802464428

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