Journal of Computational Finance
ISSN:
1460-1559 (print)
1755-2850 (online)
Editor-in-chief: Christoph Reisinger
Gaussian and Poisson approximation: applications to CDOs tranche pricing
Nicole El Karoui, Ying Jiao, David Kurtz
Abstract
ABSTRACT
This paper describes a new numerical method, based on Stein’s method and zero bias transformation, of computing collateralized debt obligation (CDO) tranche prices. We propose first-order correction terms for both Gaussian and Poisson approximations, and the approximation errors are discussed. We then combine the two approximations to price CDO tranches in the conditionally independent framework, using a realistic local correlation structure. Numerical tests show that the method provides robust results, with a very low computational burden.
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