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| Arbitrage-free Loss Surface Closest to Base Correlations by Andrei Greenberg of Rabobank International July 17, 2008 Abstract: We start from a typical base correlation loss surface and seek to rectify it by relaxing as few conditions as possible. By focusing on the areas where arbitrage occurs most often, we are able to obtain an arbitrage-free loss surface with minimum modifications and still price standard tranches within the bid-offer and most of the times, very close to the mid. The new framework generates a series of loss distributions, and thus naturally offers a solution to such issues as pricing thin tranches and parts of the capital structure outside the quoted detachment points, previously dealt with by interpolation and extrapolation of base correlations. Keywords: Base correlations, loss distribution, CDO pricing. Download paper (253K PDF) 29 pages
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