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Risk Premia in Structured Credit Derivatives

by Andreas Eckner of Stanford University

January 5, 2008

Abstract: During the past couple of years much research effort has been devoted to explaining the spread of corporate bonds over Treasuries. On the other hand, relatively little is known about the spread components of structured credit products. This paper shows that such securities compensate investors for expected losses due to defaults, pure jump-to-default risk, correlation risk, as well as the risk of firm-specific and market-wide adverse changes in credit conditions. We provide a framework that allows a decomposition of "structured" credit spreads, and we apply this decomposition to CDX index tranches.

JEL Classification: G12, G13, G33.

Keywords: credit risk, correlated default, structured credit derivatives, affine jump diffusion, tranche spread decomposition, portfolio loss decomposition.

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