Copula based simulation procedures for pricing collateralised debt obligations

Abstract

The aim of this paper is to study the impact of structure of dependency on the pricing of multi-name credit derivatives such as collateralised debt obligations (CDO). The correlation between names defaulting has an effect on the value of the basket credit derivatives. We present a copula based simulation procedure for pricing CDO under different structure of dependency and assessing the influence of different price drivers (correlation, hazard rates and recovery rates) on modelling portfolio losses. Gaussian copulas and Monte Carlo simulation are widely used to measure the default risk in basket credit derivatives. Many studies have shown that many distributions have fatter tails than those captured by the normal distribution. We use distributions with fat tails such as the t-student distribution. The paper has several practical implications that are of value for financial hedgers and engineers, financial regulators, central banks, and financial risk managers.