Explaining the Implied Correlation Smile
In the preceding Chapter 2 we outlined how a liquid and transparent market for tranched credit risk has evolved in recent years. Especially tranches linked to the reference portfolios CDX and iTraxx have become actively quoted with relatively narrow bid-ask spreads as mentioned in Schönbucher (2006). We also introduced the Gaussian one-factor copula model which has become the market standard for the valuation of index tranches (according to e.g. Burtschell et al. (2005a), Finger (2004), Friend and Rogge (2004), Duffie (2004), Hull and White (2004), and Schönbucher (2003)).
KeywordsCopula Model Gaussian Copula Default Time Base Correlation Default Intensity
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