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Consistent Valuation of Bespoke CDO Tranches

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  • Yadong Li
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    Abstract

    This paper describes a consistent and arbitrage-free pricing methodology for bespoke CDO tranches. The proposed method is a multi-factor extension to the (Li 2009) model, and it is free of the known flaws in the current standard pricing method of base correlation mapping. This method assigns a distinct market factor to each liquid credit index and models the correlation between these market factors explicitly. A low-dimensional semi-analytical Monte Carlo is shown to be very efficient in computing the PVs and risks of bespoke tranches. Numerical examples show that resulting bespoke tranche prices are generally in line with the current standard method of base correlation with TLP mapping. Practical issues such as model deltas and quanto adjustment are also discussed as numerical examples.

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    File URL: http://arxiv.org/pdf/1004.1758
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1004.1758.

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    Date of creation: Apr 2010
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    Handle: RePEc:arx:papers:1004.1758

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    Web page: http://arxiv.org/

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    1. Friedel Epple & Sam Morgan & Lutz Schloegl, 2007. "Joint Distributions Of Portfolio Losses And Exotic Portfolio Products," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 733-748.
    2. Igor Halperin, 2009. "Implied Multi-Factor Model for Bespoke CDO Tranches and other Portfolio Credit Derivatives," Papers 0910.2696, arXiv.org.
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