An Empirical Investigation of an Intensity-Based Model for Pricing CDO Tranches
47 Pages Posted: 8 May 2007 Last revised: 9 May 2008
Date Written: May 7, 2008
Using an extensive data set of 15,600 CDS and CDO tranche spreads on the North American Investment Grade CDX index I conduct an empirical analysis of a Duffie and Gârleanu (2001) intensity-based model for correlated defaults. I examine the model with respect to model assumptions, pricing in both the cross section and time series dimension, and hedging ability. The results show that the model assumptions are reasonable and that average prices are matched well. In addition, the model accurately tracks the prices over time of the more risky tranches. Finally, the model sensitivity of the most risky tranches to underlying CDS spreads match actual sensitivities better than those implied by the commonly used Gaussian copula. The last result suggests that the model is well-suited for hedging the equity tranche.
Keywords: credit risk, CDO, hedging
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