Comparison of market models for measuring and hedging synthetic CDO tranche spread risks

Original Research Paper

Abstract

The recent credit crisis has focused attention on the models used for pricing and assessing risk of structured credit transactions including synthetic CDOs. The market standard one factor Gaussian copula model has been criticized for its unrealistic constant correlation assumption. In this paper, a range of market models that allow a positive relationship between default correlation and default probability, including the correlation mapping methods and the implied copula models, are compared with the Gaussian copula model, based on their relative performance in hedging credit spread risk and pricing bespoke CDOs. The models assessed are calibrated to the traded CDO tranche spreads prior to the credit crisis and then compared based on the mean absolute pricing errors over a time period including the credit crisis. The results of the analysis highlight a number of issues including the accuracy of "mark-to-model" valuations of bespoke CDOs, the value of including past information in pricing and hedging, and the relative performance of the base correlation Gaussian copula model compared to the other market models in this study.

Keywords

Credit risk CDO Gaussian copula Base correlation Implied copula 

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Copyright information

© DAV / DGVFM 2011

Authors and Affiliations

  1. 1.School of Actuarial Studies, Australian School of BusinessUniversity of New South WalesSydneyAustralia

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