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Principles of Financial Engineering, 3rd Edition by Elsevier Science

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Chapter 22

Default Correlation Pricing and Trading

The purpose of this chapter is to explain (default) correlation trading to elaborate on the dependence of tranche prices and basket default swaps on default correlation. We first use a simple example with three assets to show how increases in default correlation increase spreads of senior tranches but decrease spreads of equity tranches. We relate this insight to recent movements in tranche spreads. We then introduce the standard market (Gaussian copula) model and apply it. We highlight similarities between compound correlations implied by this model and implied volatility from the Black–Scholes model. Compound correlations are shown to differ from base correlations. Finally, we discuss how views ...

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