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Do Not Forget the Cancellation: Marking-to-market and hedging LCDX tranches

by Péter Dobránszky of Finalyse SA, FORTIS Bank, & Katholieke Universiteit Leuven, and
Wim Schoutens of Katholieke Universiteit Leuven

March 11, 2009

Abstract: Although market is busy today working on the bullet LCDS contract to remove the cancellation feature from syndicated secured loan derivatives, in their current form LCDSs and LCDX tranches are still exposed to the cancellation risk. Until recently, in lack of proper modelling framework, market practitioners neglected the cancellation risk and they priced and hedged these products as simple CDSs and CDO tranches. However, cancellation risk does matter! Especially in the current market situation. As we show here, it is more than important to take into account the cancellation risk while marking-to-market and hedging syndicated secured loan derivatives. For this purpose, we present here an easy and robust way to model the cancellation.

JEL Classification: G10, G12, G13, G15, G20, G21.

Keywords: cancellation risk, bullet LCDS, LCDX, tranche pricing, marking-to-market, hedging, one-factor models, base correlation, Lévy copulas, stochastic recovery.

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