Correlation at First Sight

Andrew Friend and Ebbe Rogge

Economic Notes, 2005, vol. 34, issue 2, 155-183

Abstract: The synthetic collateralized debt obligation (CDO) market has, over the last year, seen a significant increase in liquidity and transparency. The availability of published prices such as TracX and iBoxx tranches permits the calibration of model parameters, which was not achievable a year ago. This paper details what we believe has become the market standard approach in CDO valuation. The valuation model is introduced and analysed in depth to develop a better practical understanding of its use and the implications of parameter selection and calibration. In particular, we examine the idea that correlation within a copula model can be seen to be an equivalent measure to volatility in a standard B&S option framework and, correspondingly, we seek to calibrate smile and skew.

Date: 2005
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