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Modeling the evolution of implied CDO correlations

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  • Marius Hofert
  • Matthias Scherer
  • Rudi Zagst

Abstract

CDO tranche spreads (and prices of related portfolio-credit derivatives) depend on the market’s perception of the future loss distribution of the underlying credit portfolio. Applying Sklar’s seminal decomposition to the distribution of the vector of default times, the portfolio-loss distribution derived thereof is specified through individual default probabilities and the dependence among obligors’ default times. Moreover, the loss severity, specified via obligors’ recovery rates, is an additional determinant. Several (specifically univariate) credit derivatives are primarily driven by individual default probabilities, allowing investments in (or hedging against) default risk. However, there is no derivative that allows separately trading (or hedging) default correlations; all products exposed to correlation risk are contemporaneously also exposed to default risk. Moreover, the abstract notion of dependence among the names in a credit portfolio is not directly observable from traded assets. Inverting the classical Vasicek/Gauss copula model for the correlation parameter allows constructing time series of implied (compound and base) correlations. Based on such time series, it is possible to identify observable variables that describe implied correlations in terms of a regression model. This provides an economic model of the time evolution of the market’s view of the dependence structure. Different regression models are developed and investigated for the European CDO market. Applications and extensions to other markets are discussed. Copyright Swiss Society for Financial Market Research 2010

Suggested Citation

  • Marius Hofert & Matthias Scherer & Rudi Zagst, 2010. "Modeling the evolution of implied CDO correlations," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(3), pages 289-308, September.
    • Handle: RePEc:kap:fmktpm:v:24:y:2010:i:3:p:289-308
    DOI: 10.1007/s11408-010-0136-8
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    References listed on IDEAS

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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    3. Rösch, Daniel, 2003. "Correlations and Business Cycles of Credit Risk: Evidence from Bankruptcies in Germany," University of Regensburg Working Papers in Business, Economics and Management Information Systems 380, University of Regensburg, Department of Economics.
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