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On break-even correlation: the way to price structured credit derivatives by replication

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  • Jean-David Fermanian
  • Olivier Vigneron

Abstract

We consider the pricing of European-style structured credit pay-off under the Gaussian Copula Model (GCM). When no sudden jump-to-default events occur, the perfect replication of these pay-offs under the GCM is obtained if and only if the underlying single-name credit spreads follow a particular family of dynamics and if the pricing parameters are given by so-called 'break-even' correlations. We exhibit a class of Merton-style models that are consistent with this result. We calculate break-even correlations explicitly to price nth-to-default baskets under the GCM. Finally, we illustrate the usefulness of this concept as a relative-value tool.

Suggested Citation

  • Jean-David Fermanian & Olivier Vigneron, 2015. "On break-even correlation: the way to price structured credit derivatives by replication," Quantitative Finance, Taylor & Francis Journals, vol. 15(5), pages 829-840, May.
    • Handle: RePEc:taf:quantf:v:15:y:2015:i:5:p:829-840
    DOI: 10.1080/14697688.2013.812233
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    1. Jean-Paul Laurent & Jon Gregory, 2005. "Basket default swaps, CDOs and factor copulas," Post-Print hal-03679517, HAL.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. Damiano Brigo & Aurélien Alfonsi, 2005. "Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model," Finance and Stochastics, Springer, vol. 9(1), pages 29-42, January.
    4. Rüdiger Frey & Jochen Backhaus, 2008. "Pricing And Hedging Of Portfolio Credit Derivatives With Interacting Default Intensities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(06), pages 611-634.
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