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Valuation Bound of Tranche Options

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  • Yadong Li
  • Ariye Shater
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    Abstract

    We performed a comprehensive analysis on the price bounds of CDO tranche options, and illustrated that the CDO tranche option prices can be effectively bounded by the joint distribution of default time (JDDT) from a default time copula. Systemic and idiosyncratic factors beyond the JDDT only contribute a limited amount of pricing uncertainty. The price bounds of tranche option derived from a default time copula are often very narrow, especially for the senior part of the capital structure where there is the most market interests for tranche options. The tranche option bounds from a default time copula can often be computed semi-analytically without Monte Carlo simulation, therefore it is feasible and practical to price and risk manage senior CDO tranche options using the price bounds from a default time copula only. CDO tranche option pricing is important in a number of practical situations such as counterparty, gap or liquidation risk; the methodology described in this paper can be very useful in the above described situations.

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    File URL: http://arxiv.org/pdf/1004.1759
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1004.1759.

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    Date of creation: Apr 2010
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    Handle: RePEc:arx:papers:1004.1759

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    Web page: http://arxiv.org/

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    1. Lando, David & Nielsen, Mads Stenbo, 2010. "Correlation in corporate defaults: Contagion or conditional independence?," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 355-372, July.
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