Coping with Copulas: Managing tail risk
by Domenico Picone of Dresdner Kleinwort,
Marco Stoeckle of Dresdner Kleinwort,
Andrea Loddo of Dresdner Kleinwort, and
Priya Shah of Dresdner Kleinwort
Abstract: Analysing default risk of credit portfolios and CDOs:
- In our CDO model series we have so far released various models with increasing flexibility and sophistication.
- While they all have the advantage of being analytical / closed form solution models, they require simplifying assumptions with respect to the way credits may default together.
- Most importantly, they all use a factor model to generate joint default events.
- If the way credits default together is introduced without a factor model:
- We can't apply the recursive algorithm anymore (as it depends on conditioning on a common factor).
- However, Monte Carlo (MC) techniques can be used to simulate joint default events.
- Within a MC approach, copulas allow for a very general and flexible way to directly model the dependency within the portfolio.
- The current credit crisis has highlighted the importance of tail events in risk management. This model gives credit investors the tool to analyse the behaviour of their credit portfolio under stressed market conditions.
Download spreadsheet : here.
Download manual (631K PDF) 13 pages
Related reading: 1 of 6 CDO model: Large Homogeneous Pool Model
2 of 6 CDO model: Large Homogeneous Pool Model, with Gauss-Hermite Integration
3 of 6 CDO model: Finite Homogeneous Pool Model
4 of 6 A Model for Longevity Swaps: Pricing life expectancy
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