Change Analysis for the Dependence Structure and Dynamic Pricing of Basket Default Swaps

Ping Li and Ze†Zheng Li

European Financial Management, 2015, vol. 21, issue 4, 646-671

Abstract: In this paper we use a type of dynamic copula method to characterise the dependence structure between financial assets and price basket default swaps (BDSs). We first employ a goodness†of†fit test and a binary segmentation procedure to analyse the change of dependence structure between the obligations underlying a BDS, then present a numerical example to demonstrate the change analysis and BDS pricing process. We find that in different time periods, the best copula fitting the data is not the same; therefore the tranche spreads of the BDS are also different. We also compare our results with those obtained from static copulas and dynamic Gaussian copulas. The results show that the static copula and dynamic Gaussian copula methods underestimate the spreads for riskier tranches and overestimate those for less risky tranches.

Date: 2015
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