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The Forward Loss Model: A dynamic term structure approach for the pricing of portfolio credit derivatives

by Nordine Bennani of the Royal Bank of Scotland

November 2, 2005

Abstract: In this paper, we present the Forward Loss Model, a practical framework for the pricing of portfolio credit derivatives. The model is given in terms of a natural underlying, the forward loss, for which an HJM-like and a market model representation are provided. We give broad and flexible classes of underlying diffusions and assess the corresponding no-arbitrage conditions. A simple, one-factor version of the FLM is implemented and calibrated to the iTraxx market. Implied term structure and dynamics of correlation are discussed, with the application to the pricing of forward starting CDO, options on CDOs and Leverage Super Senior.

Keywords: Credit Derivatives, CDO, Correlation Term Structure, Options on CDO.

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