Multiscale Intensity Models and Name Grouping for Valuation of Multi-Name Credit Derivatives

30 Pages Posted: 26 Jun 2007

See all articles by Evan Papageorgiou

Evan Papageorgiou

Princeton University

Ronnie Sircar

Princeton University - Department of Operations Research and Financial Engineering

Date Written: July 19, 2007

Abstract

The pricing of collateralized debt obligations and other basket credit derivatives is contingent upon (i) a realistic modeling of the firms' default times and the correlation between them, and (ii) efficient computational methods for computing the portfolio loss distribution from the individual firms' default time distributions. Factor models, a widely-used class of pricing models, are computationally tractable despite the large dimension of the pricing problem, thus satisfying issue (ii), but to have any hope of calibrating CDO data, numerically intense versions of these models are required. We revisit the intensity-based modeling setup for basket credit derivatives and, with the aforementioned issues in mind, we propose improvements (a) via incorporating fast mean-reverting stochastic volatility in the default intensity processes, and (b) by considering homogeneous groups within the original set of firms. This can be thought of as a hybrid of top-down and bottom-up approaches. We present a calibration example, and discuss the relative performance of the framework.

Keywords: Collateralized debt obligations, intensity-based model, stochastic volatility, asymptotic approximation, multiple time scales, homogeneous-group factor models, bottom-up, top-down

JEL Classification: G12, G13

Suggested Citation

Papageorgiou, Evan and Sircar, Ronnie, Multiscale Intensity Models and Name Grouping for Valuation of Multi-Name Credit Derivatives (July 19, 2007). Available at SSRN: https://ssrn.com/abstract=995277 or http://dx.doi.org/10.2139/ssrn.995277

Evan Papageorgiou (Contact Author)

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

HOME PAGE: http://www.princeton.edu/~evanp

Ronnie Sircar

Princeton University - Department of Operations Research and Financial Engineering ( email )

Princeton, NJ 08544
United States

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