Pricing Structured Products with Economic Covariates

52 Pages Posted: 20 Dec 2015 Last revised: 21 Feb 2019

See all articles by Yong Seok Choi

Yong Seok Choi

University of Houston - C.T. Bauer College of Business

Hitesh Doshi

University of Houston - C.T. Bauer College of Business

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business

Date Written: January 7, 2019

Abstract

We introduce a top-down no-arbitrage model for pricing structured products. The losses are described by Cox processes whose intensities depend on economic variables. The model provides economic insight into the impact of structured products on the risk exposure of financial institutions and systemic risk. We estimate the model using CDO data and find that spreads decrease with higher interest rates, and increase with volatility and leverage. Volatility is the primary determinant of variation in tranche spreads, but leverage and interest rates are more closely associated with rare credit events. Model-implied risk premiums and the probabilities of tranche losses increase substantially during the financial crisis.

Keywords: structured product, collateralized debt obligation, tranche pricing, economic determinants, risk premiums

JEL Classification: G12

Suggested Citation

Choi, Yong Seok and Doshi, Hitesh and Jacobs, Kris and Turnbull, Stuart M., Pricing Structured Products with Economic Covariates (January 7, 2019). Available at SSRN: https://ssrn.com/abstract=2705559 or http://dx.doi.org/10.2139/ssrn.2705559

Yong Seok Choi

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Hitesh Doshi

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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