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Forward Equations for Portfolio Credit Derivatives

Columbia University Center for Financial Engineering, Financial Engineering Report No. 2008-05

22 Pages Posted: 25 Apr 2008  

Rama Cont

Imperial College London; CNRS; Norges Bank Research

Ioana A. Savescu

Merrill Lynch & Co. - Merrill Lynch, UK

Date Written: 2008

Abstract

We introduce an alternative approach for computing the values of CDO tranche spreads in reduced-form models for portfolio credit derivatives ("top-down" models), which allows for efficient computations and can be used as an ingredient of an efficient calibration algorithm. Our approach is based on the solution of a system of ordinary differential equations, which is the analogue for portfolio credit derivatives of Dupire's famous equation for call option prices. It allows to efficiently price CDOs and other portfolio credit derivatives without Monte Carlo simulation.

Keywords: credit risk, portfolio credit derivatives, CDO, derivative pricing, tranche

JEL Classification: G13,C14, C63

Suggested Citation

Cont, Rama and Savescu, Ioana A., Forward Equations for Portfolio Credit Derivatives (2008). Columbia University Center for Financial Engineering, Financial Engineering Report No. 2008-05. Available at SSRN: https://ssrn.com/abstract=1124954 or http://dx.doi.org/10.2139/ssrn.1124954

Rama Cont (Contact Author)

Imperial College London ( email )

London, SW7 2AZ
United Kingdom

HOME PAGE: http://www3.imperial.ac.uk/people/r.cont

CNRS ( email )

Laboratoire de Probabilites & Modeles aleatoires
Universite Pierre & Marie Curie (Paris VI)
Paris, 75252
France

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

Norges Bank Research ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Ioana SAVESCU

Merrill Lynch & Co. - Merrill Lynch, UK ( email )

Merrill Lynch Financial Centre
2 King Edward Street
LONDON, EC1A 1HQ
United Kingdom

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