Pricing distressed CDOs with base correlation and stochastic recovery rates

In 2008 and 2009, the calibration of the standard Gaussian copula model for collateralised debt obligations has frequently broken down. To overcome that problem, Martin Krekel has embedded the model with correlated stochastic recovery rates. He shows that with his extension the calibration range of standard tranches is significantly widened and, moreover, 60–100% tranches can be priced

During the financial crisis, it was often impossible to calibrate the Gaussian copula credit portfolio model with base correlation and fixed recovery rates (also known as the standard Gaussian copula model) to the complete set of CDX and iTraxx investment-grade collateralised debt obligation (CDO) tranche quotes. For instance, within the CDX investment grade series 9 it failed for the 15–30% senior tranche and hence the successive 30–100% tranche. The reason is that the standard Gaussian copula

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