Dynamic Implied Correlation Modeling and Forecasting in Structured Finance
by Sebastian Löhr of Leibniz University of Hannover,
June 28, 2012
Abstract: Correlations are the main drivers for credit portfolio risk and constitute a major element in pricing structured financial instruments such as synthetic single tranche collateralized debt obligations (STCDOs). This paper suggests a dynamic panel re-gression approach to model and forecast implied correlations. Random effects are introduced to account for unobservable time-specific effects on implied tranche correlations. Implied correlation forecasts are compared to forecasts using historical correlations from asset returns. The empirical findings support our proposed dynamic mixed-effects regression correlation model (MERM) even during the global financial crisis and indicate several implications for pricing and hedging credit derivatives.
Keywords: Base Correlation, Dynamic Panel Regression, Implied Correlation, Single Tranche Collateralized Debt Obligation, Spread Forecast, Systematic Risk, Tranche.
Previously titled: Dynamic Correlation Modeling in Structured Finance