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Authors
Advisor(s)
Abstract(s)
This paper proposes a top-down model for pricing Collateralized Debt Obligation (CDOs). Our proposal is both treatable and realistic, in the sense we are able to obtain closed-form solutions to single tranche CDOs and capturing extreme credit events. We use as key ingredients the so-called (T, x)-bonds, as proposed in Filipovic, Overbeck, and Schmidt (2008), but generalize their affine specificationby including shot-noise processes. Our claim is that affine diffusions combined with shot-noise processes lead to an improved modeling of CDO spreads in comparison to existing affine jump-diffusion models. The proposed approach allows in particular for better capturing the possibility of extreme events, like the ones underlying the current crisis. We illustrate our results with a very concrete (simple) instance of our class of models. Finally, we identify the connections between the top-down and bottom-up approaches for modeling credit risk, within our class of models. Concretely, we show that even when taking a bottom-up approach the aggregate loss process would be a process of affine shot-noise type.
Description
Keywords
CDOs Shot-Noise Processes Affine Models
Pedagogical Context
Citation
Gaspar, Raquel M. and Thorsten Schmidt. (2008). "CDOs in the light of the current crisis". Instituto Superior de Economia e Gestão. Departamento de Gestão – ADVANCE .Working paper nº 2-08.
Publisher
ISEG - Departamento de Gestão