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Inside the CDO Correlation Surface

Posted: 2 May 2014 Last revised: 26 Jan 2015

Vilimir Yordanov

Independent

Date Written: December 31, 2013

Abstract

No-arbitrage surfaces implied from the parameters of benchmark stochastic financial models attracted considerable attention. They are convenient objects that statically give access to the marginals of the state variables and dynamically to their law. The former help to price vanillas and to detect arbitrage in a model-free way, the latter to properly hedge and price exotics. For equity derivatives such research made significant advances recently. Strikingly, for portfolio credit derivatives it is missing. The purpose of the paper is to provide such. We employ the peculiar property that a CDO swap both has a convex pay-off on the total portfolio loss and could be characterized by intensity with the loss being bounded and increasing. In this way, it bears the features simultaneously of equity and fixed income securities respectively. We use that to give a characterization of the correlation surface the CDO market implies, its asymptotics, and basic dynamic properties.

Keywords: CDO, correlation, copula, compensator, intensity

JEL Classification: G13

Suggested Citation

Yordanov, Vilimir, Inside the CDO Correlation Surface (December 31, 2013). Available at SSRN: https://ssrn.com/abstract=2430947

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