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Principles of Financial Engineering, 2nd Edition by Salih N. Neftci

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CHAPTER 18

Credit Indices and Their Tranches

1. Introduction

In this chapter we introduce the modeling of collateralized debt obligations and their tranches. The chapter also deals with credit indices and their implications in creating tranched securities. In particular we discuss the standard tranches.

Tranching a basket of credit-risky instruments makes the trading and pricing of credit correlation possible. Once we learn how to strip correlation from tranched products we can price it and then trade it. The issues are discussed within credit default context, but the techniques themselves are very general and buying and selling correlation is routinely applied in creating equity and FX-based structured products as well. Yet, in this chapter ...

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