A Note on Markov Functional Loss Models
by Nordine Bennani of Dresdner Kleinwort
Abstract: In this paper, we present an extension of the Forward Loss Model as presented initially in . The Markov Functional Loss Model will allow for an even simpler and tractable approach for pricing correlation products. After describing the main ideas and details of the framework, we apply it to the calibration of the index tranche market, with a particular focus on the 10Y market. We question the general approach to term structure calibration as a pure bootstrapping, and provide an alternative solution. We give numerical examples in which we show an almost perfect fit to all maturities, for both iTraxx and CDX.