Pricing CDO tranches in an intensity based model with the mean reversion approach

JiangLun Wu, Wei Yang

Research output: Contribution to journalArticle

6 Citations (Scopus)

Abstract

We discuss the phenomenon of mean reversion in credit risk market and propose a class of models, in the framework of intensity based model, where the default intensity is composed of a common component and a idiosyncratic component which are specified by independent mean reverting stochastic processes of the following Markovian type
where θ≥0 is the long-term mean value, the parameter σ≥0 stands for the scaling of the volatility, and α(X(t),t) is the mean correction with the function α:R×[0,∞)↦α(x,t)∈R being twice differentiable in x and differentiable in t, and W(t) is a Brownian motion. We demonstrate how this class of models can be used to price synthetic CDOs and present a closed-form solution of tranche spreads in synthetic CDOs.
Original languageEnglish
Pages (from-to)814-825
Number of pages12
JournalMathematical and Computer Modelling
Volume52
Issue number5-6
DOIs
Publication statusPublished - Sep 2010

Keywords

  • credit risk
  • intensity based model
  • mean reversion
  • collateralized debt obligations (CDOs)
  • cashflow CDO
  • synthetic CDO

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