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LÚvy Subordinator Model of Default Dependency

by BS Balakrishna of unaffiliated

July 22, 2010

Abstract: This article presents a model of default dependency based on LÚvy subordinator. It is a tractable dynamical model, computationally structured similar to the one-factor Gaussian copula model, providing easy calibration to individual hazard rate curves and efficient pricing with Fast Fourier Transform techniques. The subordinator is an alpha=1/2 stable LÚvy process, maximally skewed to the right, with its distribution function known in closed form as the LÚvy distribution. The model provides a reasonable fit to market data with just two parameters to assess dependency risk, a measure of correlation and that of the likelihood of a catastrophe.

JEL Classification: G12, G13.

Keywords: CDO, Default Risk, LÚvy Distribution, LÚvy Subordinator, FFT, Gaussian Copula.

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