A Comparative Analysis of Correlation Skew Modeling Techniques for CDO Index Tranches
by Claudio Ferrarese of King's College London
September 8, 2006
Abstract: In this work we present an analysis of CDO pricing models with a focus on "correlation skew models". These models are extensions of the classic single factor Gaussian copula and may generate a skew. We consider examples with fat tailed distributions, stochastic and local correlation which generally provide a closer fit to market quotes. We present an additional variation of the stochastic correlation framework using normal inverse Gaussian distributions. The numerical analysis is carried out using a large homogeneous portfolio approximation.
Keywords: default risks, CDOs, index tranches, factor model, copula, correlation skew, stochastic correlation.