EMPIRICAL COPULAS FOR CDO TRANCHE PRICING USING RELATIVE ENTROPY

Michael A. H. Dempster (), Elena A. Medova () and Seung W. Yang ()
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Michael A. H. Dempster: Centre for Financial Research, Judge Business School, University of Cambridge, United Kingdom;
Elena A. Medova: Centre for Financial Research, Judge Business School, University of Cambridge, United Kingdom;
Seung W. Yang: Centre for Financial Research, Judge Business School, University of Cambridge, United Kingdom;

International Journal of Theoretical and Applied Finance (IJTAF), 2007, vol. 10, issue 04, 679-701

Abstract: We discuss the general optimization problem of choosing a copula with minimum entropy relative to a specified copula and a computationally intensive procedure to solve its dual. These techniques are applied to constructing an empirical copula for CDO tranche pricing. The empirical copula is chosen to be as close as possible to the industry standard Gaussian copula while ensuring a close fit to market tranche quotes. We find that the empirical copula performs noticeably better than the base correlation approach in pricing non-standard tranches and that the market view of default dependence is influenced by maturity.

Keywords: Portfolio credit risk; CDO; copula; entropy; non-parametric estimation (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (5)

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DOI: 10.1142/S0219024907004391

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