Base Expected Loss explains Lévy Base Correlation Smile

by João Garcia of Dexia Group, and
Serge Goossens of Dexia Bank

July 28, 2007

Abstract: In an earlier paper we introduced Lévy base correlation. In this paper we look at base expected loss at maturity both in the Gaussian copula and Lévy based models and link it to base correlation in these frameworks. We report on the existence of smile in both base correlation curves and discuss different interpolation methodologies in view of absence of arbitrage. Finally we discuss the properties of these curves for tranchlet pricing purposes.

JEL Classification: C60.

Keywords: Base Expected Loss, Base Correlation, CDO, Loss Distribution, Lévy Process, Gaussian Copula, Interpolation, Absence of Arbitrage.

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