Factor models for credit correlation

Stewart Inglis and Alex Lipton describe dynamic and static factor models for credit correlation, and show how the static model can be calibrated to the market and used for the pricing of standard and bespoke tranches, including tranchelets

Credit default swaps (CDSs) represent insurance contracts on individual obligors, synthetic collateralised default obligations (CDOs) represent various tranches of baskets backed by CDSs and cash CDOs are backed by corporate bonds, mortgages and other assets. Originally, the Gaussian Copula approach was used to price CDO tranches (see, for example, Li (2000)). Unfortunately, in its basic form it is incapable of reproducing market prices. Several researchers have tried to generalise it with some

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