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Dynamic Conditioning and Credit Correlation Baskets

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  • Albanese, Claudio
  • Vidler, Alicia

Abstract

Dynamic conditioning is a technique that allows one to formulate correlation models for large baskets without incurring in the curse of dimensionality. The individual price processes for each reference name can be described by a lattice model specified semi-parametrically or even nonparametrically and which can realistically have about 1000 sites. The time discretization step is chosen so small to satisfy the Courant stability condition and is typically of about a few hours. This constraint ensures needed smoothness for the single name probability kernels which can thus be directly manipulated. A flexible multi-factor correlation model can be obtained by means of conditioning trees corresponding to binomial processes with jumps. There is one conditioning tree associated to each reference names, one associated to each industry sector and a global one to the basket itself. Since the conditioning trees are correlated, the underlying processes are also mutually correlated. In this paper, we discuss a modeling framework for CDOs based on dynamic conditioning in greater detail than previously done in our other papers. We also show that the model calibrates well to index tranches throughout in the period from 2005 to the Spring of 2008 and yields instructive insights.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 8368.

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Date of creation: 25 Jan 2008
Date of revision: 21 Apr 2008
Handle: RePEc:pra:mprapa:8368

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Keywords: CDO; pricing; dynamic conditioning; correlation modeling; semi-parametric; operator methods;

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  1. Albanese, Claudio & Chen, Oliver X., 2006. "Implied migration rates from credit barrier models," Journal of Banking & Finance, Elsevier, Elsevier, vol. 30(2), pages 607-626, February.
  2. Lucas, Andr‚ & Klaassen, Pieter & Spreij, Peter, 1999. "An analytic approach to credit risk of large corporate bond and loan portfolios," Serie Research Memoranda, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics 0018, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics.
  3. Claudio Albanese & Adel Osseiran, 2007. "Moment Methods for Exotic Volatility Derivatives," Papers 0710.2991, arXiv.org.
  4. Albanese, Claudio & Vidler, Alicia, 2007. "A STRUCTURAL MODEL FOR CREDIT-EQUITY DERIVATIVES AND BESPOKE CDOs," MPRA Paper 5227, University Library of Munich, Germany, revised 09 Sep 2007.
  5. Albanese, Claudio, 2006. "Operator Methods, Abelian Processes And Dynamic Conditioning," MPRA Paper 5246, University Library of Munich, Germany, revised 06 Nov 2007.
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