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Risk-Neutral Correlations in the Pricing and Hedging of Basket Credit Derivatives

by Michael Walker of the University of Toronto

November 2, 2004

Abstract: Whereas a widely-held current view is that the correlation parameters occurring in the risk-neutral procedure for the pricing of basket credit derivatives should, at least in principle, be set equal to their real-world values obtained from historical data, the conclusion of this article is that the correlation parameters are risk-neutral parameters with a range of allowable values. As a result, buyers and sellers of basket credit derivatives have a wide range of arbitrage-free prices to choose from, and it is the market, not risk-neutral pricing, that determines, both in principle and in practice, a definite price.

Keywords: basket credit derivatives, correlations, collateralized debt obligations.

Published in: Journal of Credit Risk, Vol. 1, No. 1, (Winter 2004/2005), pp. 131-139.

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