Correlation breakdown, copula credit default models and arbitrage

Rodanthy Tzani and Alexios P. Polychronakos

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Abstract: The recent "correlation breakdown" in the modeling of credit default swaps, in which model correlations had to exceed 100% in order to reproduce market prices of supersenior tranches, is analyzed and argued to be a fundamental market inconsistency rather than an inadequacy of the specific model. As a consequence, markets under such conditions are exposed to the possibility of arbitrage. The general construction of arbitrage portfolios under specific conditions is presented.

Date: 2009-08
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Published in Published in Global Association of Risk Professionals Magazine, December 2008 Issue, p.37

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