Minimum-Entropy Calibration of CDO Tranches

by Sascha Meyer-Dautrich of UniCredit MIB, and
Christoph Wagner of UniCredit MIB

May 29, 2007

Abstract: We apply a minimal entropy calibration algorithm to the pricing of CDO tranches. Formulated in the quantile space under the risk-neutral default measure the measure change from the uniform prior only needs to explain the correlation skew and can thus be interpreted as market price of correlation risk. This change of measure mechanism calibrates by construction exactly to the market quotes and is then used to obtain arbitrage free non-standard tranche prices.

Keywords: CDO tranche pricing, minimal entropy calibration, market price of correlation risk.

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