Advanced Credit Portfolio Modeling and CDO Pricing

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Advanced Credit Portfolio Modeling and CDO Pricing

by Ernst Eberlein of the University of Freiburg,
Rüdiger Frey of the University of Leipzig, and
Ernst August von Hammerstein of the University of Freiburg

September 14, 2007

Abstract: We discuss two different approaches for modeling dependence in a credit portfolio. First we extend the factor model approach using generalized hyperbolic distributions. It is crucial that we can choose the parameters of the distribution for the idiosyncratic factor independently of those for the systematic factor. The excellent performance of this modeling approach is shown in the context of CDO pricing. In the last section we introduce a dynamic Markov chain model for the default state of a credit portfolio and discuss again pricing of CDO tranches.

JEL Classification: G13.

Keywords: credit portfolio, CDO pricing, factor model, generalized hyperbolic distributions, dynamic Markov chain model.

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