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Pricing structured products with economic covariates

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  • Choi, Yong Seok
  • Doshi, Hitesh
  • Jacobs, Kris
  • Turnbull, Stuart M.

Abstract

We introduce a top-down no-arbitrage model for pricing structured products. Losses are described by Cox processes whose intensities depend on economic variables. The model provides economic insight into the impact of structured products on financial institutions’ risk exposure and systemic risk. We estimate the model using CDO data and find that spreads decrease with higher interest rates and increase with volatility and leverage. Volatility is the primary determinant of variation in tranche spreads. Leverage and interest rates are more closely associated with rare credit events. Model-implied risk premiums and the probabilities of tranche losses increase substantially during the financial crisis.

Suggested Citation

  • Choi, Yong Seok & Doshi, Hitesh & Jacobs, Kris & Turnbull, Stuart M., 2020. "Pricing structured products with economic covariates," Journal of Financial Economics, Elsevier, vol. 135(3), pages 754-773.
    • Handle: RePEc:eee:jfinec:v:135:y:2020:i:3:p:754-773
    DOI: 10.1016/j.jfineco.2019.08.002
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    References listed on IDEAS

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    Cited by:

    1. Bernd Engelmann & Ha Pham, 2020. "A Raroc Valuation Scheme for Loans and Its Application in Loan Origination," Risks, MDPI, vol. 8(2), pages 1-20, June.

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    More about this item

    Keywords

    Structured product; Collateralized debt obligation; Tranche pricing; Economic determinants; Risk premiums;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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