IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this article

A Dynamic Approach To The Modeling Of Correlation Credit Derivatives Using Markov Chains

Listed author(s):


    (Deutsche Bank AG, Great Winchester Street, London EC2N 2DB, UK)

  • L. C. G. ROGERS


    (Statistical Laboratory, University of Cambridge, Wilberforce Road, Cambridge CB3 0WB, UK)

The modeling of credit events is in effect the modeling of the times to default of various names. The distribution of individual times to default can be calibrated from CDS quotes, but for more complicated instruments, such as CDOs, the joint law is needed. Industry practice is to model this correlation using a copula/base correlation approach, which suffers significant deficiencies. We present a new approach to default correlation modeling, where defaults of different names are driven by a common continuous-time Markov process. Individual default probabilities and default correlations can be calculated in closed form. We provide semi-analytic formulas for the pricing of CDO tranches via Laplace-transform techniques which are both fast and easy to implement. The model calibrates to quoted tranche prices with a high degree of precision and allows one to price non-standard tranches in a consistent and arbitrage-free manner. The number of parameters of the model is flexible and can be adjusted to adapt to the set of market data one is calibrating to. More importantly, the model is dynamically consistent and can be used to price options on tranches and other exotic path-dependent products.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: Access to full text is restricted to subscribers.

File URL:
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 12 (2009)
Issue (Month): 01 ()
Pages: 45-62

in new window

Handle: RePEc:wsi:ijtafx:v:12:y:2009:i:01:p:45-62
Contact details of provider: Web page:

Order Information: Email:

No references listed on IDEAS
You can help add them by filling out this form.

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:wsi:ijtafx:v:12:y:2009:i:01:p:45-62. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Tai Tone Lim)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.