Correlation at First Sight

by Andrew Friend of ABN AMRO, and
Ebbe Rogge of ABN AMRO & London and Imperial College

October 28, 2004

Abstract: The synthetic CDO market has, over the last year, seen a significant increase in liquidity and transparency. The availability of published prices such as TracX and iBoxx tranches permit calibration of model parameters in a way that was not achievable a year ago.

This paper details what we believe has become the market standard approach in CDO valuation. The valuation model is introduced and analyzed in depth to develop a better practical understanding of its use and the implications of parameter selection and calibration. In particular we examine the idea that correlation within a copula model can be seen to be an equivalent measure to volatility in a standard B&S option-framework and correspondingly we seek to calibrate smile and skew.

Keywords: Portfolio Credit Risk Models, Copula Functions, Credit Derivatives.

Published in: Economic Notes, Vol. 34, No. 2, (July 2005), pp. 155-183.

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