Incorporating multi-dimensional tail dependencies in the valuation of credit derivatives

Noel McWilliam, Kar-Wei Loh and Huan Huang

Quantitative Finance, 2011, vol. 11, issue 12, 1803-1814

Abstract: The need for an accurate representation of tail risk has become increasingly acute in the wake of the credit crisis. We introduce a hyper-cuboid normal mixture copula that permits the representation of complex tail-dependence structures in a multi-dimensional setting. We outline an efficient pattern-recognition calibration methodology that can identify tail dependencies independent of the number of risk factors considered. This model is used to develop a new framework for pricing credit derivative instruments, and we derive semi-analytical and analytical pricing formulae for a first-to-default swap and illustrate with an example valuation. Model assumptions are validated against iTraxx Series 5 equity data over an 8-year period. Identification and representation of tail dependencies is crucial to further the study of contagion dynamics, and our model provides a basis for future research in this area.

Date: 2011
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DOI: 10.1080/14697688.2010.544324

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