Implied Correlation in CDO Tranches: A Paradigm to be Handled with Care

9 Pages Posted: 25 Nov 2006

See all articles by Roberto Torresetti

Roberto Torresetti

Banco Popolare

Damiano Brigo

Imperial College London - Department of Mathematics

Andrea Pallavicini

Banca IMI; Imperial College London - Department of Mathematics

Date Written: November 22, 2006

Abstract

We illustrate the two main types of implied correlation one may obtain from market CDO tranche spreads. Compound correlation is more consistent at single tranche level but for some market CDO tranche spreads cannot be implied. Base correlation is less consistent but more flexible and can be implied for a much wider set of CDO tranche market spreads. Furthermore, base correlation is more easily interpolated and leads to the possibility to price non-standard detachments. Even so, base correlation may lead to negative expected tranche losses, thus violating basic no-arbitrage conditions. We illustrate these features with numerical examples.

Keywords: Implied Correlation, Base Correlation, Compound Correlation, Expected Tranche Loss, DJ iTraxx, CDX, CDO Tranche, Back-Test, No-Arbitrage Conditions

JEL Classification: G16

Suggested Citation

Torresetti, Roberto and Brigo, Damiano and Pallavicini, Andrea, Implied Correlation in CDO Tranches: A Paradigm to be Handled with Care (November 22, 2006). Available at SSRN: https://ssrn.com/abstract=946755 or http://dx.doi.org/10.2139/ssrn.946755

Roberto Torresetti (Contact Author)

Banco Popolare ( email )

Milan
Italy

Damiano Brigo

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

Andrea Pallavicini

Banca IMI ( email )

Largo Mattioli 3
Milan, MI 20121
Italy
+39 02 7261 (Phone)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

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