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Comparing Some Alternative LÚvy Base Correlation Models for Pricing and Hedging CDO Tranches

by Viktoriya Masol of Katholieke Universiteit Leuven & EURANDOM, and
Wim Schoutens of Katholieke Universiteit Leuven

March 2008

Abstract: In this paper we investigate alternative LÚvy base correlation models that arise from the Gamma, Inverse Gaussian and CMY distribution classes. We compare these models to the basic (exponential) LÚvy base correlation model and the classical Gaussian base correlation model. For all the investigated models, the LÚvy base correlation curve is significantly flatter than the corresponding Gaussian one, which indicates better correspondence of the LÚvy models with reality. Furthermore, we present the results of pricing bespoke tranchlets and comparing deltas of both standard and custom-made tranches under all the considered models. We focus on deltas with respect to CDS index and individual CDS, and the hedge ratio for hedging the equity tranche with the junior mezzanine.

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