A Tractable Multivariate Default Model Based on a Stochastic Time-Change

International Journal of Theoretical and Applied Finance, Vol. 12, No. 2, pp. 227-249, 2009

Posted: 20 Apr 2010

See all articles by Matthias A. Scherer

Matthias A. Scherer

Technische Universität München (TUM)

Jan-Frederik Mai

Technische Universität München (TUM) - HVB Institute for Mathematical Finance

Date Written: March 1, 2009

Abstract

A stochastic time-change is applied to introduce dependence to a portfolio of credit-risky assets whose default times are modeled as random variables with arbitrary distribution. The dependence structure of the vector of default times is completely separated from its marginal default probabilities, making the model analytically tractable. This separation is achieved by restricting the time-change to suitable Lévy subordinators which preserve the marginal distributions. Jump times of the Lévy subordinator are interpreted as times of excess default clustering. Relevant for practical implementations is that the parameters of the time-change allow for an intuitive economical explanation and can be calibrated independently of the marginal default probabilities. On a theoretical level, a so-called time normalization allows to compute the resulting copula of the default times. Moreover, the exact portfolio-loss distribution and an approximation for large portfolios under a homogeneous portfolio assumption are derived. Given these results, the pricing of complex portfolio derivatives is possible in closed-form. Three different implementations of the model are proposed, including a compound Poisson subordinator, a Gamma subordinator, and an Inverse Gaussian subordinator. Using two parameters to adjust the dependence structure in each case, the model is capable of capturing the full range of dependence patterns from independence to complete comonotonicity. A simultaneous calibration to portfolio-CDS spreads and CDO tranche spreads is carried out to demonstrate the model's applicability.

Keywords: Lévy subordinator, Cuadras-Augé copula, CDO pricing, portfolio-loss process, multivariate default model

Suggested Citation

Scherer, Matthias A. and Mai, Jan-Frederik, A Tractable Multivariate Default Model Based on a Stochastic Time-Change (March 1, 2009). International Journal of Theoretical and Applied Finance, Vol. 12, No. 2, pp. 227-249, 2009, Available at SSRN: https://ssrn.com/abstract=1515468

Matthias A. Scherer

Technische Universität München (TUM) ( email )

Arcisstrasse 21
Munich, DE 80333
Germany

Jan-Frederik Mai (Contact Author)

Technische Universität München (TUM) - HVB Institute for Mathematical Finance ( email )

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
499
PlumX Metrics