Multiscale intensity models and name grouping for valuation of multi-name credit derivatives

Evan Papageorgiou, Ronnie Sircar

Research output: Contribution to journalArticle

8 Scopus citations

Abstract

The pricing of collateralized debt obligations (CDOs) and other basket credit derivatives is contingent upon (i) a realistic modelling of the firms' default times and the correlation between them, and (ii) efficient computational methods for computing the portfolio loss distribution from the individual firms' default time distributions. Factor models, a widely used class of pricing models, are computationally tractable despite the large dimension of the pricing problem, thus satisfying issue (ii), but to have any hope of calibrating CDO data, numerically intense versions of these models are required. We revisit the intensity-based modelling setup for basket credit derivatives and, with the aforementioned issues in mind, we propose improvements (a) via incorporating fast mean-reverting stochastic volatility in the default intensity processes, and (b) by considering homogeneous groups within the original set of firms. This can be thought of as a hybrid of top-down and bottom-up approaches. We present a calibration example, including data in the midst of the 2008 financial credit crisis, and discuss the relative performance of the framework.

Original languageEnglish (US)
Pages (from-to)353-383
Number of pages31
JournalApplied Mathematical Finance
Volume16
Issue number4
DOIs
StatePublished - Dec 1 2009

All Science Journal Classification (ASJC) codes

  • Finance
  • Applied Mathematics

Keywords

  • Collateralized debt obligations
  • asymptotic approximation
  • bottom-up
  • homogeneous-group factor models
  • intensity-based model
  • multiple time scales
  • stochastic volatility
  • top-down

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