Dynamic Implied Correlation Modeling and Forecasting in Structured Finance
Journal of Futures Markets 33 (11), 994-1023 (2013)
47 Pages Posted: 10 Nov 2013 Last revised: 19 Nov 2015
Date Written: April 18, 2013
Correlations are the main drivers for credit portfolio risk and constitute a Major element in pricing credit derivatives such as synthetic single-tranche collateralized debt obligation swaps. This paper suggests a dynamic panel regression Approach to model and forecast implied correlations. Random effects are introduced to account for unobservable time-specific effects on implied tranche correlations. The implied-correlation forecasts of tranche spreads are compared to forecasts using historical correlations from asset returns. The empiricalfindings support our proposed dynamic mixed-effects Regression correlation model.
Keywords: Base Correlations, Dynamic Panel Regression, Implied Correlations, Single-tranche Collateralized Debt Obligations, Spread Forecast
JEL Classification: C23, C51, C53, G21, G24
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