Intensity Gamma: A New Approach to Pricing Portfolio Credit Derivatives

Abstract

We develop a completely new model for correlation of credit defaults based on a financially intuitive concept of business time similar to that in the Variance Gamma model for stock price evolution. Solving a simple equation calibrates each name to its credit spread curve and we show that the overall model can be calibrated to the market base correlation curve of a tranched CDO index. Once this calibration is performed, obtaining consistent arbitrage-free prices for non-standard tranches, products based on different underlying names and even more exotic products such as CDO2 is straightforward and rapid.

Keywords: portffolio credit derivatives, gamma process, CDO

JEL Classification: C19