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Computational Techniques for basic Affine Models of Portfolio Credit Risk

by Andreas Eckner of Stanford University

August 2009

Abstract: This paper presents computational techniques that make a certain class of fully dynamic intensity-based models for portfolio credit risk, along the lines of Duffie and Gārleanu (2001) and Mortensen (2006), just as computationally tractable as the Gaussian copula model. For this model, we improve the fit to tranche spreads by a factor of around three, by allowing for a more flexible correlation structure, and by accounting for market frictions due to bid-offer spreads. The resulting model can be used to hedge a wide range of risks in the credit market, such as the risk of changes in correlations, volatilities, or idiosyncratic default risk.

JEL Classification: C63, G12, G33.

Keywords: credit risk, correlated default, structured credit derivatives, affine jump diffusion, intensity-based model, CDO pricing

Published in: Journal of Computational Finance, Vol. 13, No. 1, (Fall 2009), pp. 63-97.

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