On break-even correlation: the way to price structured credit derivatives by replication

Jean-David Fermanian and Olivier Vigneron

Quantitative Finance, 2015, vol. 15, issue 5, 829-840

Abstract: We consider the pricing of European-style structured credit pay-off under the Gaussian Copula Model (GCM). When no sudden jump-to-default events occur, the perfect replication of these pay-offs under the GCM is obtained if and only if the underlying single-name credit spreads follow a particular family of dynamics and if the pricing parameters are given by so-called 'break-even' correlations. We exhibit a class of Merton-style models that are consistent with this result. We calculate break-even correlations explicitly to price nth-to-default baskets under the GCM. Finally, we illustrate the usefulness of this concept as a relative-value tool.

Date: 2015
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DOI: 10.1080/14697688.2013.812233

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