Factor Distributions Implied by Quoted CDO Spreads Tranche Pricing

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Factor Distributions Implied by Quoted CDO Spreads Tranche Pricing

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Erik Schlögl () (School of Finance and Economics, University of Technology, Sydney)
Lutz Schlögl

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Erik Schlogl

Abstract

The rapid pace of innovation in the market for credit risk has given rise to a liquid market in synthetic collateralised debt obligation (CDO) tranches on standardised portfolios. To the extent that tranche spreads depend on default dependence between different obligors in the reference portfolio, quoted spreads can be seen as aggregating the market views on this dependence. In a manner reminiscent of the volatility smiles found in liquid option markets, practitioners speak of implied correlation ?smiles? and ?skews?. We explore how this analogy can be taken a step further to extract implied factor distributions from the market quotes for synthetic CDO tranches.

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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 190.

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Length: 12
Date of creation: 01 Jan 2007
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Handle: RePEc:uts:rpaper:190

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References listed on IDEAS
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Jondeau, Eric & Rockinger, Michael, 2001. "Gram-Charlier densities," Journal of Economic Dynamics and Control, Elsevier, vol. 25(10), pages 1457-1483, October. [Downloadable!] (restricted)
Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October. [Downloadable!] (restricted)
Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March. [Downloadable!] (restricted)

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