A Note on the Correlation Smile

15 Pages Posted: 23 Mar 2006

See all articles by Svenja Hager

Svenja Hager

University of Tuebingen - Faculty of Economics and Business Administration

Rainer Schoebel

University of Tuebingen - Faculty of Economics and Social Sciences

Date Written: December 2005

Abstract

The correct modeling of default dependence is essential for the valuation of multiname credit derivatives. However for the pricing of synthetic CDOs a one-factor Gaussian copula model with constant and equal pairwise correlations, default intensities and recovery rates for all assets in the reference portfolio has become the standard market model. If this model were a reflection of market opinion there wouldn't be the implied correlation smile that is observed in the market. The purpose of this paper is to explain the structure of the smile by discussing the influence of different correlation matrices on CDO spreads.

Keywords: credit derivatives, CDOs, correlation smile

JEL Classification: G13

Suggested Citation

Hager, Svenja and Schoebel, Rainer, A Note on the Correlation Smile (December 2005). Available at SSRN: https://ssrn.com/abstract=893041 or http://dx.doi.org/10.2139/ssrn.893041

Svenja Hager (Contact Author)

University of Tuebingen - Faculty of Economics and Business Administration ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Rainer Schoebel

University of Tuebingen - Faculty of Economics and Social Sciences ( email )

Mohlstrasse 36
D-72074 Tuebingen
Germany
+49 7071 2977088 (Phone)

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