Credit models and the crisis, or: how I learned to stop worrying and love the CDOs

Details Credit models and the crisis, or: how I learned to stop worrying and love the CDOs Credit models and the crisis, or: how I learned to stop worrying and love the CDOs

2009-12-30

arxiv.org/abs/0912.5427v3

Economy

Quantitative Finance

Pricing of Securities

A vastly extended and updated version of this paper will appear as a book: "Credit models and the crisis: a journey into CDOs,

Scientific paper

We follow a long path for Credit Derivatives and Collateralized Debt Obligations (CDOs) in particular, from the introduction of the Gaussian copula model and the related implied correlations to the introduction of arbitrage-free dynamic loss models capable of calibrating all the tranches for all the maturities at the same time. En passant, we also illustrate the implied copula, a method that can consistently account for CDOs with different attachment and detachment points but not for different maturities. The discussion is abundantly supported by market examples through history. The dangers and critics we present to the use of the Gaussian copula and of implied correlation had all been published by us, among others, in 2006, showing that the quantitative community was aware of the model limitations before the crisis. We also explain why the Gaussian copula model is still used in its base correlation formulation, although under some possible extensions such as random recovery. Overall we conclude that the modeling effort in this area of the derivatives market is unfinished, partly for the lack of an operationally attractive single-name consistent dynamic loss model, and partly because of the diminished investment in this research area.

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