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A note on the correlation smile

Author

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  • Hager, Svenja
  • Schöbel, Rainer

Abstract

The correct modeling of default dependence is essential for the valuation of multiname credit derivatives. However for the pricing of synthetic CDOs a one-factor Gaussian copula model with constant and equal pairwise correlations, default intensities and recovery rates for all assets in the reference portfolio has become the standard market model. If this model were a reflection of market opinion there wouldn't be the implied correlation smile that is observed in the market. The purpose of this paper is to explain the structure of the smile by discussing the influence of different correlation matrices on CDO spreads.

Suggested Citation

  • Hager, Svenja & Schöbel, Rainer, 2005. "A note on the correlation smile," Tübinger Diskussionsbeiträge 297, University of Tübingen, School of Business and Economics.
  • Handle: RePEc:zbw:tuedps:297
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    File URL: https://www.econstor.eu/bitstream/10419/40330/1/517736365.pdf
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    Cited by:

    1. Balakrishna, B S, 2006. "A Semi-Analytical Parametric Model for Dependent Defaults," MPRA Paper 14918, University Library of Munich, Germany, revised 15 May 2007.

    More about this item

    Keywords

    default risk; CDOs; implied correlation smile; correlation matrx; heterogeneity;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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