Intensity Gamma: A New Approach to Pricing Portfolio Credit Derivatives

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Intensity Gamma: A New Approach to Pricing Portfolio Credit Derivatives

by Mark Joshi of the Royal Bank of Scotland, and
Alan Stacey of the Royal Bank of Scotland

May 11, 2005

Abstract: We develop a completely new model for correlation of credit defaults based on a financially intuitive concept of business time similar to that in the Variance Gamma model for stock price evolution. Solving a simple equation calibrates each name to its credit spread curve and we show that the overall model can be calibrated to the market base correlation curve of a tranched CDO index. Once this calibration is performed, obtaining consistent arbitrage-free prices for non-standard tranches, products based on different underlying names and even more exotic products such as CDO² is straightforward and rapid.

Keywords: CDO, correlation smile, gamma process, CDO-squared.

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