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.