engleski

Pricing and calibration in market models

The goal of this article is to study in detail the pricing and calibration in market models for credit portfolios. Starting from the framework of market models proposed in Eberlein, Grbac, and Schmidt (2013), we consider a slightly simplified setup which eases calibration. This leads to a new class of affine models which are highly tractable. Conditions for absence of arbitrage under various types of contagion are given and valuation formulas for single tranche CDOs and options on CDO spreads are obtained. A simple two-factor affine diffusion model is calibrated to iTraxx data using the EM-algorithm together with an extended Kalman filter. The model shows a very good fit to all tranches and all maturities over the full observation period of four years.

CDO, loss process, contagion, single tranche CDO, top-down model, market model, affine processes, EM-algorithm, extended Kalman filter, iTraxx

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