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Pricing Distressed CDOs with Base Correlation and Stochastic Recovery

by Martin Krekel of UniCredit

May 22, 2008

Abstract: In February and March 2008 it was temporarily not possible to calibrate the standard Gaussian Base correlation model to the complete set of CDX.IG and ITRAXX.IG CDO tranche quotes. For instance, in CDX.IG it failed for the 15% - 30% senior tranche and hence the sucessive 30% - 100% tranche. The reason is that the Gaussian Base correlation model was not able to generate enough probability for high portfolio losses, while preserving the calibration to mezzanine and equity tranches. We introduce a Gaussian Base correlation model with correlated stochastic recovery rates to overcome this problem. Moreover, our model can be used to price super senior tranches (e.g. 60% - 100%), which have a fair spread of zero in a standard copula model with fixed recovery.

JEL Classification: G13.

Keywords: CDO, Base correlation, Stochastic Recovery, Credit Basket, Tranche Pricing.

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