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Modeling Correlation Structure for Collateralized Debt Obligations

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  • Deniz Ilalan

Abstract

Pricing complex financial derivatives such as collateralized debt obligations (CDO) is considered as the main reason triggering the 2008 financial crisis. The correlation structure related to the credit risks involved in a portfolio for pricing issues have been tried to overcome via a Gaussian copula framework first introduced by David Li (2000). This approach regards the correlation among the credit risks as normally distributed (tied with a Gaussian copula framework), enabling us to derive analytical solutions. However, despite its simplicity, this approach is far from reality, which caused mispricing of the tranches of CDOs. This phenomenon is called the correlation smile. This paper takes the correlation smile issue by considering a Levy copula framework. When this is introduced to pricing equations, one can see that the correlation smile is ¡°corrected¡±. Thus, a more accurate model of pricing the above-mentioned tranches is introduced.

Suggested Citation

  • Deniz Ilalan, 2015. "Modeling Correlation Structure for Collateralized Debt Obligations," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 6(2), pages 72-83, April.
    • Handle: RePEc:jfr:ijfr11:v:6:y:2015:i:2:p:72-83
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    References listed on IDEAS

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    1. Kallsen, Jan & Tankov, Peter, 2006. "Characterization of dependence of multidimensional Lévy processes using Lévy copulas," Journal of Multivariate Analysis, Elsevier, vol. 97(7), pages 1551-1572, August.
    2. Anna Schlösser, 2011. "Pricing and Risk Management of Synthetic CDOs," Lecture Notes in Economics and Mathematical Systems, Springer, number 978-3-642-15609-0, February.
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