RT Journal Article
SR Electronic
T1 A Poisson Model with Common Shocks for CDO Valuation
JF The Journal of Fixed Income
FD Institutional Investor Journals
SP 72
OP 81
DO 10.3905/jfi.2004.461453
VO 14
IS 3
A1 Lee, Chih-Wei
A1 Kuo, Cheng-Kun
A1 Urrutia, Jorge Luis
YR 2004
UL http://jfi.pm-research.com/content/14/3/72.abstract
AB A collateralized debt obligation is a credit risk product created in tranches from a portfolio of debt instruments. To value tranches, it is critical to model multiple default correlations in order to derive the appropriate loss function. Conditional independence is the usual assumption in this regard, but it ignores meaningful correlated shocks. Models assuming conditional dependence are improvements except that the number of parameters makes model calibration very challenging. A Poisson model with common shocks for derivation of the CDO loss function assumes conditional dependence and reduces the number of model parameters by grouping firms with equal credit ratings. Implementation becomes more efficient, and such a model can correct the tranche mispricing produced by the assumption of conditional independence.