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Seminars

Pricing and Hedging of Portfolio Credit Derivatives: Recent Developments and New Challenges

Date: 10-19-2006
Start Time: 1:00pm
End Time: 2:00pm
Speaker: Philipp Schönbucher, Swiss Federal Institute of Technology
Location: Mudd 303

Abstract

The current market standard Gauss copula model for the pricing of CDOs is reaching its limits in terms of calibration, hedging performance, and ability to price innovative structures such as forward-starting CDOs, index options, and options on CDOs. After an analysis of these problems, we present a model which is able to overcome the limitations of the Gauss copula model. The model implies a change in focus from individual obligors to the cumulative loss process of the whole credit portfolio and of its probability distribution. We represent this loss distribution of the portfolio using forward transition rates which have a similar function to forward rates in models of the term-structure of interest-rates. This allows a straightforward calibration of the model.

We then discuss how the stochastic evolution of the loss distribution can be modeled by equipping the transition rates with stochastic dynamics and provide restrictions on these dynamics which ensure absence of arbitrage in the model. Like in HJM-type interest-rate models, the arbitrage-free dynamics are then fully determined by the specification of the volatilities of the transition rates.

Bio

Professor Philipp Schönbucher is assistant professor of risk management at the Department of Mathematics of the Swiss Federal Institute of Technology (ETH), Zurich. He holds degrees in mathematics (Oxford) and economics (Bonn) and a Ph.D. in economics (Bonn). His publications include papers on credit risk modeling, credit derivatives pricing, stochastic volatility modeling, option pricing in illiquid markets, real options, and term structure models. His main area of research is credit risk modeling and credit derivatives pricing, in which he has been active since 1996; he is consultant and professional trainer to a number of leading financial institutions.