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Wiping the Smile Off Your Base (Correlation Curve)

by Ed Parcell of Derivative Fitch, and
James Wood of Derivative Fitch

June 21, 2007

Abstract: We discuss problems with interpolating and extrapolating base correlation curves and examine the pricing of CDO tranches with non-standard subordination levels. We introduce an alternative risk measure, the expected loss of equity tranches. We calculate upper and lower boundaries on "base EL", and set out the behaviours that base EL must obey. We investigate interpolation schemes that best avoid model arbitrage. We also look at the calculated prices and sensitivities for tranches using these different methods.

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