Valuation of Loan CDS and Synthetic Loan CDO with Prepayment Risk

by Michael (Hong) Liang of Industrial Bank CO., LTD.

March 23, 2009

Abstract: We present a simple model to price LCDS and synthetic Loan CDO with prepayment risk. The implementation is semi-analytic, which facilitates fast and accurate risk calculations. The model is flexible and stable, and is able to fit exactly the market prices of all the LCDX tranches including the 15-100% super senior tranche. The prepayment rate parameter in the model is well behaved and the impact on correlation skew is simple and intuitive.

JEL Classification: G10, G12, G13.

Keywords: prepayment risk, LCDS, LCDX, CDO, copula model, base correlation skew.

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