Advances in Mathematical Finance

Part of the series Applied and Numerical Harmonic Analysis pp 259-277

A Generic One-Factor Lévy Model for Pricing Synthetic CDOs

  • Hansjörg AlbrecherAffiliated withAustrian Academy of Sciences, Johann Radon InstituteDepartment of Mathematics, Graz University of Technology
  • , Sophie A. LadoucetteAffiliated withDepartment of Mathematics, Katholieke Universiteit Leuven
  • , Wim SchoutensAffiliated withDepartment of Mathematics, Katholieke Universiteit Leuven

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The one-factor Gaussian model is well known not to fit the prices of the different tranches of a collateralized debt obligation (CDO) simultaneously, leading to the implied correlation smile. Recently, other one-factor models based on different distributions have been proposed. Moosbrucker [12] used a one-factor Variance-Gamma (VG) model, Kalemanova et al. [7] and Guégan and Houdain [6] worked with a normal inverse Gaussian (NIG) factor model, and Baxter [3] introduced the Brownian Variance-Gamma (BVG) model. These models bring more flexibility into the dependence structure and allow tail dependence. We unify these approaches, describe a generic one-factor Lévy model, and work out the large homogeneous portfolio (LHP) approximation. Then we discuss several examples and calibrate a battery of models to market data.

Key words

Lévy processes collateralized debt obligation (CDO) credit risk credit default large homogeneous portfolio approximation