Thursday, October 6, 2011

Short note on Vasicek CDO pricing model

- It is a PRICING model, not a credit default rate model (i.e. neither structural nor reduced-form, it takes prob. of default as input)
- It assumes (in its most simple form) large, homogeneous pool
- It assumes Gaussian copula (can be relaxed)
- Just like B-S option pricing has implied volatility, Vasicek CDO pricing has implied correlation
- In its simplest form, the correlation matrix is assumed to be time-independent and all pairwise correlations are identical
- Industry people use Vasicek implied correlation as a convenient way to quote tranche price (cf. Black volatilities for cap/floor/swaption)
- Not surprisingly, the implied correlation is not constant across tranches - correlation smile
- Base correlation is smoother than compound correlation

Ref: This article by Elizalde

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