A Simple Dynamic Model for Pricing and Hedging Heterogenous CDOs
by Andrei V. Lopatin of NumeriX, LLC
November 29, 2009
Abstract: We present a simple bottom-up dynamic credit model that can be calibrated simultaneously to the market quotes on CDO tranches and individual CDSs constituting the credit portfolio. The model is most suitable for the purpose of evaluating the hedge ratios of CDO tranches with respect to the underlying credit names. Default intensities of individual assets are modeled as deterministic functions of time and the total number of defaults accumulated in the portfolio. To overcome numerical difficulties, we suggest a semi-analytic approximation that is justified by the large number of portfolio members. We calibrate the model to the recent market quotes on CDO tranches and individual CDSs and find the hedge ratios of tranches. Results are compared with those obtained within the static Gaussian Copula model.
Keywords: default contagion, loss distribution, Markovian projection, synthetic CDO, tranche delta.
This paper is Published as Ch. 4 in...