Saturday, May 17, 2008

An Improved Implied Copula Model And Its Application To The Valuation Of Bespoke CDO Tranches

by John Hull and Alan White of the University of Toronto

Abstract: In Hull and White (2006) we showed how CDO quotes can be used to imply a probability distribution for the average hazard rate over the life of the CDO. This is known as the “implied copula approach.” In this paper we develop a parameterization of the implied copula approach and show how it can be used for valuing bespoke CDOs. Both homogeneous and heterogeneous versions of the model are presented and the differences between the results obtained from the two versions of the model are examined. The model can be extended to incorporate two factors so that European and North American hazard rates are less than perfectly correlated.

Download paper (1,067K PDF) 28 pages

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