Abstract
With the spread widening of the CDO tranches in the main credit indices and the recovery assumption of 40% it becomes impossible to calibrate the standard Gaussian Copula model to certain spread levels during this credit crunch period. In addition, the fact that the market starts to quote the tranche [60%,100%] indicates that this recovery assumption is flawed. To resolve this issue we introduce a new methodology for CDS and CDO pricing with stochastic recovery rates. The stochasticity of the recovery was introduced at the CDS level which made the CDS pricing more consistent.
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