Multi-Factor Bottom-Up Model for Pricing Credit Derivatives
AbstractIn this note we continue the study of the stress event model, a simple and intuitive dynamic model for credit risky portfolios, proposed by Duffie and Singleton (1999). The model is a bottom-up version of the multi-factor portfolio credit model proposed by Longstaff and Rajan (2008). By a novel identification of independence conditions, we are able to decompose the loss distribution into a series expansion which not only provides a clear picture of the characteristics of the loss distribution but also suggests a fast and accurate approximation for it. Our approach has three important features: (i) it is able to match the standard CDS index tranche prices and the underlying CDS spreads, (ii) the computational speed of the loss distribution is very fast, comparable to that of the Gaussian copula, (iii) the computational cost for additional factors is mild, allowing for more ﬂexibility for calibrations and opening the possibility of studying multi-factor default dependence of a portfolio via a bottom-up approach. We demonstrate the tractability and efficiency of our approach by calibrating it to investment grade CDS index tranches.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 23090.
Date of creation: 18 May 2010
Date of revision:
credit derivatives; CDO; bottom-up approach; multi-name; intensity-based; risk and portfolio.;
Find related papers by JEL classification:
- C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-06-11 (All new papers)
- NEP-BAN-2010-06-11 (Banking)
- NEP-RMG-2010-06-11 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Darrell Duffie & Jun Pan & Kenneth Singleton, 1999.
"Transform Analysis and Asset Pricing for Affine Jump-Diffusions,"
NBER Working Papers
7105, National Bureau of Economic Research, Inc.
- Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
- Francis A. Longstaff & Arvind Rajan, 2008.
"An Empirical Analysis of the Pricing of Collateralized Debt Obligations,"
Journal of Finance,
American Finance Association, vol. 63(2), pages 529-563, 04.
- Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
- Erhan Bayraktar & Bo Yang, 2009. "Multi-Scale Time-Changed Birth Processes for Pricing Multi-Name Credit Derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 16(5), pages 429-449.
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