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Implied Multi-Factor Model for Bespoke CDO Tranches and other Portfolio Credit Derivatives

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  • Igor Halperin

Abstract

This paper introduces a new semi-parametric approach to the pricing and risk management of bespoke CDO tranches, with a particular attention to bespokes that need to be mapped onto more than one reference portfolio. The only user input in our framework is a multi-factor model (a "prior" model hereafter) for index portfolios, such as CDX.NA.IG or iTraxx Europe, that are chosen as benchmark securities for the pricing of a given bespoke CDO. Parameters of the prior model are fixed, and not tuned to match prices of benchmark index tranches. Instead, our calibration procedure amounts to a proper reweightening of the prior measure using the Minimum Cross Entropy method. As the latter problem reduces to convex optimization in a low dimensional space, our model is computationally efficient. Both the static (one-period) and dynamic versions of the model are presented. The latter can be used for pricing and risk management of more exotic instruments referencing bespoke portfolios, such as forward-starting tranches or tranche options, and for calculation of credit valuation adjustment (CVA) for bespoke tranches.

Suggested Citation

  • Igor Halperin, 2009. "Implied Multi-Factor Model for Bespoke CDO Tranches and other Portfolio Credit Derivatives," Papers 0910.2696, arXiv.org.
  • Handle: RePEc:arx:papers:0910.2696
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    Cited by:

    1. Alexander Veremyev & Peter Tsyurmasto & Stan Uryasev & R. Rockafellar, 2014. "Calibrating probability distributions with convex-concave-convex functions: application to CDO pricing," Computational Management Science, Springer, vol. 11(4), pages 341-364, October.
    2. Igor Halperin & Andrey Itkin, 2013. "USLV: Unspanned Stochastic Local Volatility Model," Papers 1301.4442, arXiv.org, revised Mar 2013.
    3. Yadong Li, 2010. "Consistent Valuation of Bespoke CDO Tranches," Papers 1004.1758, arXiv.org.

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