Extreme Events and the Copula Pricing of Commercial Mortgage-Backed Securities

Abstract:     
Commercial mortgage-backed securities (CMBS), as a portfolio-based financial product, have gained great popularity in financial markets. This paper extends Childs, Ott and Riddiough's (1996, JFQA) model by proposing a copula-based methodology for pricing CMBS bonds. Default on underlying commercial mortgages within a pool is a crucial risk associated with CMBS transactions. Two important issues associated with such default - extreme events and default dependencies among the mortgages - have been identified to play crucial roles in determining credit risk in the pooled commercial mortgage portfolios. This article pays particular attention to these two issues in pricing CMBS bonds. Our results show the usefulness and potential of copula-based models in pricing CMBS bonds, and the ability of such models to correctly price CMBS tranches of different seniorities. It is also important to sufficiently consider complex default dependence structure and the likelihood of extreme events occurring in pricing various CMBS bonds.

Keywords: CMBS, copula model, extreme events, heavy tail, tail dependence

Accepted Paper Series