Collateralized Debt Obligations Pricing and Actor Models: A New Methodology Using Normal Inverse Gaussian Distributions
29 Pages Posted: 11 May 2006
Date Written: June 2005
The reported correlation smile in the CDO market is proof that the spreads of CDOs tranches are not consistent when we use the widely-known Gaussian one-factor model for the pricing. We introduce a new methodology in which non-standard tranches such as bespoke single tranches can be valued. The underlying idea of our framework is to use the tranches' price quotes available in the market to determine the implied distribution of the common factor for a given correlation level. In our methodology the estimated correlation between the underlying assets of a CDO's underlying portfolio becomes an input. We propose an improvement to the market standard model by using Normal Inverse Gaussian distributions and we show that our approach is theoretically and empirically more accurate.
Keywords: CDO pricing, implied correlation, implied distribution, loss distribution, factor models, Normal Inverse Gaussian distribution, default probability, conditional default probability
JEL Classification: G12, G13
Suggested Citation: Suggested Citation