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Base Expected Loss explains LÚvy Base Correlation Smile

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

July 28, 2007

Abstract: In an earlier paper we introduced LÚvy base correlation. In this paper we look at base expected loss at maturity both in the Gaussian copula and LÚvy 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, LÚvy Process, Gaussian Copula, Interpolation, Absence of Arbitrage.

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