An Improved Implied Copula Model and its Application to the Valuation of Bespoke CDO Tranches

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An Improved Implied Copula Model and its Application to the Valuation of Bespoke CDO Tranches

by John Hull of the University of Toronto, and
Alan White of the University of Toronto

June 2008

Abstract: In Hull and White (2006) we showed how CDO quotes can be used to imply a probability distribution for the hazard rate over the life of the CDO. This is known as the “implied copula approach.” In this paper we develop a parametric version of the implied copula approach and show how it can be used for valuing bespoke CDOs. Both homogeneous and heterogeneous versions of the model are presented and the differences between the results obtained from the two versions of the model are examined. Results are also presented for the situation where the model is extended so that hazard rates are driven by more than one factor.

Keywords: CDO, Bespoke, Copula, Implied.

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