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Mixed copula model with stochastic correlation for CDO pricing

Author

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  • Chen, Jianli
  • Liu, Zhen
  • Li, Shenghong

Abstract

This paper deals with the problem of pricing credit derivatives portfolio—CDO. The article assumes that the systematic factor and idiosyncratic factors subject to the fat-tailed mixed G-VG distribution instead of the traditional Gaussian distribution in the framework of factor model. Thus, the G-VG copula model is established. Stochastic correlation is also incorporated to account for the correlation skew problem. The semi-analytical expressions for conditional default probability, cumulative loss distribution function and expected tranche loss are explicitly derived in the G-VG copula models under large homogeneous portfolio approximation. Thus the CDO price can be determined. The numerical analysis is carried out and the properties of the new models with those of the traditional models are compared. Results show that new models not only provide a closer fit to the market quotes, but also bring more flexibility into the dependence structure.

Suggested Citation

  • Chen, Jianli & Liu, Zhen & Li, Shenghong, 2014. "Mixed copula model with stochastic correlation for CDO pricing," Economic Modelling, Elsevier, vol. 40(C), pages 167-174.
    • Handle: RePEc:eee:ecmode:v:40:y:2014:i:c:p:167-174
    DOI: 10.1016/j.econmod.2014.03.031
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    References listed on IDEAS

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    1. Lutz Schloegl & Dominic O’Kane, 2005. "A note on the large homogeneous portfolio approximation with the Student-t copula," Finance and Stochastics, Springer, vol. 9(4), pages 577-584, October.
    2. Elisa Luciano & Wim Schoutens, 2006. "A multivariate jump-driven financial asset model," Quantitative Finance, Taylor & Francis Journals, vol. 6(5), pages 385-402.
    3. Jean-Paul Laurent & Jon Gregory, 2005. "Basket default swaps, CDOs and factor copulas," Post-Print hal-03679517, HAL.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Nguyen, Cuong & Bhatti, M. Ishaq & Komorníková, Magda & Komorník, Jozef, 2016. "Gold price and stock markets nexus under mixed-copulas," Economic Modelling, Elsevier, vol. 58(C), pages 283-292.
    2. Pourkhanali, Armin & Kim, Jong-Min & Tafakori, Laleh & Fard, Farzad Alavi, 2016. "Measuring systemic risk using vine-copula," Economic Modelling, Elsevier, vol. 53(C), pages 63-74.
    3. Meng-Jou Lu & Cathy Yi-Hsuan Chen & Wolfgang Karl Härdle, 2017. "Copula-based factor model for credit risk analysis," Review of Quantitative Finance and Accounting, Springer, vol. 49(4), pages 949-971, November.
    4. Lu, Meng-Jou & Chen, Cathy Yi-Hsuan & Härdle, Karl Wolfgang & Härdle, 2015. "Copula-Based Factor Model for Credit Risk Analysis," SFB 649 Discussion Papers SFB649DP2015-042, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    5. Meng-Jou Lu & Cathy Yi-Hsuan Chen & Wolfgang Karl Hardle, 2020. "Copula-Based Factor Model for Credit Risk Analysis," Papers 2009.12092, arXiv.org, revised Oct 2020.

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