A New Framework for Dynamic Credit Portfolio Loss Modelling

International Journal of Theoretical and Applied Finance, Vol. 11, No. 2, pp. 163-197, 2008

Posted: 30 Nov 2009

Abstract

We present the SPA framework, a novel approach to the modeling of the dynamics of portfolio default losses. In this framework, models are specified by a two-layer process. The first layer models the dynamics of portfolio loss distributions in the absence of information about default times. This background process can be explicitly calibrated to the full grid of marginal loss distributions as implied by initial CDO tranche values indexed on maturity, as well as to the prices of suitable options. We give sufficient conditions for consistent dynamics. The second layer models the loss process itself as a Markov process conditioned on the path taken by the background process. The choice of loss process is non-unique. We present a number of choices, and discuss their advantages and disadvantages. Several concrete model examples are given, and valuation in the new framework is described in detail. Among the specific securities for which algorithms are presented are CDO tranche options and leveraged super-senior tranches.

Keywords: Dynamic model of CDOs, dynamic copula, conditional Markov process, options on tranches, option on CDO tranche, portfolio loss, SPA model, leveraged super-senior

Suggested Citation

Sidenius, Jakob and Piterbarg, Vladimir and Andersen, Leif B.G., A New Framework for Dynamic Credit Portfolio Loss Modelling. International Journal of Theoretical and Applied Finance, Vol. 11, No. 2, pp. 163-197, 2008. Available at SSRN: https://ssrn.com/abstract=1515629

Jakob Sidenius (Contact Author)

Independent ( email )

No Address Available

Vladimir Piterbarg

Independent ( email )

No Address Available

Leif B.G. Andersen

Bank of America Merrill Lynch ( email )

One Bryant Park
New York, NY 10036
United States
646-855-1835 (Phone)

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