Credit Derivative Strategies: New Thinking on Managing Risk and Return

CHAPTER 10

CDO Valuation

SANTA FEDERICO, ANDREA PETRELLI, JUN ZHANG, AND VIVEK KAPOOR

 

 

 

We employ here a latent variable framework, which accounts for default correlation by introducing common factors among the variables themselves. Two semianalytical approaches are described—namely Fourier transform and direct calculation of the convolution integral via a recursive method. We present the formulation in a loss continuum framework and later we briefly describe the mapping of relevant quantities after having discredited the loss support for numerical integration.

Default Mechanism

Define the latent variable X_i = f(w)Z_i, the normal standardized asset return Z_i has a systematic component and an idiosyncratic one (Z _i = √p Z + √1−ρ ε _i), w is ...