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Composite Basket Model

by Pedro A.C. Tavares of Merrill Lynch,
Thu-Uyen Nguyen of Merrill Lynch,
Alexander Chapovsky of Merrill Lynch, and
Igor Vaysburd of Merrill Lynch

July 21, 2004

Abstract: In this paper, we propose a new methodology for quoting loss baskets (and potentially diversified FTD baskets) in a consistent manner that overcomes the problems associated with simple Gaussian copula models. We find that the model calibrates reasonably well to the 5yr and 10yr iTraxx Europe tranches, the 5yr and 10yr iTraxx North America tranches and the standardized, diversified FTD baskets currently quoted in the broker market. In light of these results, we postulate that the model should also be extensible to bespoke portfolios.

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