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Multi-Factor Bottom-Up Model for Pricing Credit Derivatives

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  • Tsui, L. K.

Abstract

In this note we continue the study of the stress event model, a simple and intuitive dynamic model for credit risky portfolios, proposed by Duffie and Singleton (1999). The model is a bottom-up version of the multi-factor portfolio credit model proposed by Longstaff and Rajan (2008). By a novel identification of independence conditions, we are able to decompose the loss distribution into a series expansion which not only provides a clear picture of the characteristics of the loss distribution but also suggests a fast and accurate approximation for it. Our approach has three important features: (i) it is able to match the standard CDS index tranche prices and the underlying CDS spreads, (ii) the computational speed of the loss distribution is very fast, comparable to that of the Gaussian copula, (iii) the computational cost for additional factors is mild, allowing for more flexibility for calibrations and opening the possibility of studying multi-factor default dependence of a portfolio via a bottom-up approach. We demonstrate the tractability and efficiency of our approach by calibrating it to investment grade CDS index tranches.

Suggested Citation

  • Tsui, L. K., 2010. "Multi-Factor Bottom-Up Model for Pricing Credit Derivatives," MPRA Paper 23090, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:23090
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    File URL: https://mpra.ub.uni-muenchen.de/23090/1/MPRA_paper_23090.pdf
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    References listed on IDEAS

    as
    1. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    2. Francis A. Longstaff & Arvind Rajan, 2008. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," Journal of Finance, American Finance Association, vol. 63(2), pages 529-563, April.
    3. Erhan Bayraktar & Bo Yang, 2009. "Multi-Scale Time-Changed Birth Processes for Pricing Multi-Name Credit Derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 16(5), pages 429-449.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    credit derivatives; CDO; bottom-up approach; multi-name; intensity-based; risk and portfolio.;

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics

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