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Correlation at First Sight

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  • Andrew Friend
  • Ebbe Rogge

Abstract

The synthetic collateralized debt obligation (CDO) market has, over the last year, seen a significant increase in liquidity and transparency. The availability of published prices such as TracX and iBoxx tranches permits the calibration of model parameters, which was not achievable a year ago. This paper details what we believe has become the market standard approach in CDO valuation. The valuation model is introduced and analysed in depth to develop a better practical understanding of its use and the implications of parameter selection and calibration. In particular, we examine the idea that correlation within a copula model can be seen to be an equivalent measure to volatility in a standard B&S option framework and, correspondingly, we seek to calibrate smile and skew.

Suggested Citation

  • Andrew Friend & Ebbe Rogge, 2005. "Correlation at First Sight," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 34(2), pages 155-183, July.
    • Handle: RePEc:bla:ecnote:v:34:y:2005:i:2:p:155-183
    DOI: 10.1111/j.0391-5026.2005.00148.x
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    References listed on IDEAS

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    1. Giesecke, Kay & Weber, Stefan, 2003. "Cyclical correlations, credit contagion, and portfolio losses," SFB 373 Discussion Papers 2003,11, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    2. Stefan Weber & Kay Giesecke, 2003. "Credit Contagion and Aggregate Losses," Computing in Economics and Finance 2003 246, Society for Computational Economics.
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    Cited by:

    1. Claudio, Ferrarese, 2006. "A comparative analysis of correlation skew modeling techniques for CDO index tranches," MPRA Paper 1668, University Library of Munich, Germany.
    2. Giuseppe Genovese & Ashkan Nikeghbali & Nicola Serra & Gabriele Visentin, 2022. "Universal approximation of credit portfolio losses using Restricted Boltzmann Machines," Papers 2202.11060, arXiv.org, revised Apr 2023.
    3. Gong, Xiao-Li & Xiong, Xiong, 2021. "Multi-objective portfolio optimization under tempered stable Lévy distribution with Copula dependence," Finance Research Letters, Elsevier, vol. 38(C).
    4. Choroś-Tomczyk, Barbara & Härdle, Wolfgang Karl & Okhrin, Ostap, 2013. "Valuation of collateralized debt obligations with hierarchical Archimedean copulae," Journal of Empirical Finance, Elsevier, vol. 24(C), pages 42-62.

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