Optimal Stochastic Recovery for Base Correlation
by Salah Amraoui of BNP PARIBAS, and
Abstract: On the back of monoline protection unwind and positive gamma hunting, spreads of the senior tranches of the CDX investment-grade index have widened so much that they went beyond the maximum spread levels that standard Gaussian Copula model can allow. Indeed, using a 40% recovery assumption and 100% default correlation gives a spread of 39bp on the 5Y [30 - 100] tranche while the market price was 55bp on June, 27 th 2008 with a CDX.IG9 ref of 148bp.
Keywords: Credit Derivatives, CDO, Stochastic recovery.