Pricing Multiname Credit Derivatives: Heavy Tailed Hybrid Approach

28 Pages Posted: 11 Jan 2002

See all articles by Roy Mashal

Roy Mashal

Lehman Brothers, New York

Marco Naldi

Barclays

Date Written: January 7, 2002

Abstract

In recent years, credit derivatives have become the main tool for transferring and hedging credit risk. The credit derivatives market has grown rapidly both in volume and in the breadth of the instruments it offers. Among the most complicated of these instruments are the multiname ones. These are instruments with payoffs that are contingent on the default realization in a portfolio of names. The modeling of dependent defaults is difficult because there is very little historical data available about joint defaults and because the prices of those instruments are not quoted. Therefore, the models cannot be calibrated, neither to defaults nor to prices.

In this paper, we present a methodology for the estimation, simulation, and pricing of multiname contingent instruments. Our model is a hybrid of the well-known structural and reduced form approaches for modeling defaults. The dependence structure of our model is of a t-copula that possesses non-trivial tail dependence. Compared with the commonly used normal-copula,the t-copula allows for more joint extreme events, which have a big impact on the prices of multiname instruments, e.g. nth-to-default baskets and CDOs. We demonstrate this impact with nth-to-default baskets.

Keywords: Credit risk, credit derivatives, copula functions, portfolio models

JEL Classification: G13

Suggested Citation

Mashal, Roy and Naldi, Marco, Pricing Multiname Credit Derivatives: Heavy Tailed Hybrid Approach (January 7, 2002). Available at SSRN: https://ssrn.com/abstract=296402 or http://dx.doi.org/10.2139/ssrn.296402

Roy Mashal (Contact Author)

Lehman Brothers, New York ( email )

745 Seventh Avenue
New York, NY 10019
United States

HOME PAGE: http://www.faculty.idc.ac.il/roy/

Marco Naldi

Barclays ( email )

745 7th Avenue
Floor 2
New York, NY
United States

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