Thesis for a degree at the Master of advanced

studies in Finance program at ETH and Uni-

versity of Z urich.
Pricing Basket of credit derivatives and CDO
in factor models framework
Under the supervision of Prof. Dr. Philipp
Sch onbucher
1
Contents
1 Intoduction 3
2 Preliminaries 4
2.1 Some notes on Copula . . . . . . . . . . . . . . . . . . . . . 4
2.1.1 Notation . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.2 Copula Functions . . . . . . . . . . . . . . . . . . . . . 4
2.2 Modelling default times . . . . . . . . . . . . . . . . . . . . . . 7
3 Factor models 9
3.1 One factor gaussian copula . . . . . . . . . . . . . . . . . . . . 9
3.2 One factor archimedean copula . . . . . . . . . . . . . . . . . 9
4 Basket of credit derivatives 10
4.1 Number of defaults distribution . . . . . . . . . . . . . . . . . 10
4.1.1 Getting the distribution of k-th-to-default by the semi-
explicit formula . . . . . . . . . . . . . . . . . . . . . . 10
4.1.2 The fast fourier transform . . . . . . . . . . . . . . . . 11
4.2 Explicit Survival distribution of the rst-to-default . . . . . . 11
4.3 Survival distribution of the k-th to default time . . . . . . . . 11
4.4 Pricing basket of credit derivatives . . . . . . . . . . . . . . . 12
4.4.1 Pricing the premium leg of k-th-to-default time . . . . 12
4.4.2 Pricing the default leg of the k-th to default time . . . 12
4.4.3 Example . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.4.4 Example . . . . . . . . . . . . . . . . . . . . . . . . . . 13
5 Hedging of credit derivatives basket 14
6 CDO(collateralised debt obligation) 16
6.1 Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
6.2 Calculating the loss distribution . . . . . . . . . . . . . . . . . 16
6.3 Pricing Formulas and Simple Consequences . . . . . . . . . . . 17
7 Conclusion 18
2
Pricing Basket of credit derivatives
and CDO in factor models framework
Lionel Gomez Sanchez

March 31, 2004

Abstract
We consider a factor approach for the pricing of credit derivatives basket and syn-
thetic CDO tranches for given default probabilities of obligors. Our goal is to deal
in a convenient way with dependent defaults for a large number of names. We pro-
vide semi-explicit expressions for small number of names and apply the FFT(fast
fourier transform) technique for the pricing of large names credit derivatives bas-
ket. We also compare prices under Gaussian and Clayton copulas and price CDO
according to risk payments conventions.
1 Intoduction
Recent years have seen a substantial growth in the size of the credit deriva-
tives market and the development and analysis of quantitative models for
credit losses has become a focus of attention for practitioners, regulators and
academics.
Here we focus on the pricing of credit derivatives basket and CDO (collat-
eralised debt obligation). Our goal is to describe an applicable, ecient
technique for large names basket. This is done thanks to the factor approach
which enables us to provide semi-explicit expressions that reduces the compu-
tational time compared with Monte Carlo simulations techniques for basket
credit derivatives of small names whereas for large names FFT is applied to
get the number of defaults distribution. To express dependencies between
times of default, Gaussian and Clayton copulas have been considered.

MAS Master of advanced studies in nance, ETH and University of Z urich Switzerland.
lionel sanchez55@yahoo.com key words: basket credit derivatives, copula, default risk,
factor models, synthetic CDOs. I would like to thank the supervisor for my masters
thesis Professor Philipp J. Schonbucher for his valuable comments and for his avalaibilty.
3
2 Preliminaries
2.1 Some notes on Copula
2.1.1 Notation
For functions that use vectors x = (x
1
, . . . , x
N
) as arguments we use the
following notation if we replace the i-th component of x with y:
f(x
i
, y) := f(x
1
, , x
i1
, y, x
i+1
, , x
N
).
1 is the vector (1, . . . , 1) and 0 = (0, . . . , 0). Comparisons between vectors
are meant component-wise. Vectors of functions F
i
: R R are written as
F(x) := (F
1
(x
1
), F
2
(x
2
), . . . , F
N
(x
N
)).
All ltered probability spaces in this paper are assumed to satisfy the usual
conditions.
2.1.2 Copula Functions
In the following we want to model the dependence structure of the defaults
between several obligors. In this section we present some basic tools for our
dependency-modelling approach. Further details on dependency modelling
and copula functions and the proofs of the propositions in this subsection
can be found in the excellent books by Joe (1997), and Nelsen (1999). Let
X
1
, X
2
, . . . , X
N
denote real-valued random variables dened on the prob-
ability space (, F, P). Let F
i
(x) be the distribution function of X
i
for
1 i N. For continuous distribution functions F
i
note the following
elementary fact :
Proposition 1 Let X denote a continuous random variable with distribution
function F then Z = F(X) has a uniform distribution on [0, 1].
The dependence structure of real-valued random variables is completely de-
scribed by their joint distribution. The joint distribution F of the random
variables X
1
, X
2
, . . . , X
N
is:
F(x) = P(X
1
x
1
, X
2
x
2
, . . . , X
N
x
n
)
The basic idea of the analysis of dependency with copula functions is that the
joint distribution function F can be separated into two parts. The rst part is
4
represented by the distribution functions of the random variables (marginals)
and the other part is the dependence structure between the random variables
which is described by the copula function.
Denition 1 A copula is any function C : R
N
[0, 1] which has the fol-
lowing properties:
(i) C(1
i
, v
i
) = v
i
for all i = 1, . . . , N, v
i
[0, 1] and for every v =
(v
1
, . . . , v
n
) [0, 1]
N
, C((v)) = 0 if at least one cordinate of the vector
v is 0;
(ii) for all a, b [0, 1]
N
with a b the volume of the hypercube with corners
a and b is positive, i.e we have
2

i
1
=1
2

i
2
=1
. . .
2

i
N
=1
(1)
i
1
+i
2
++i
N
C(v
i
1
, v
i
2
, . . . , v
i
N
) 0
where v
j
1
= a
j
and v
j
2
= b
j
for all j = 1, . . . , N.
This denition ensures that the copula can be used as a distribution function
on [0, 1]
N
. The simplest example of a copula is the product copula which
corresponds to the uniform distribution on [0, 1]
N
. The basis of the analysis
of multivariate dependence with copula functions is the following theorem of
Sklar (1996):
Theorem 1 (Sklar) Let X
1
, . . . , X
N
be random variables with marginal dis-
tribution functions F
1
, F
2
, . . . , F
N
and joint distribution function F. Then
there exists a N dimensional copula C such that for all x R
N
,
F(x) = C(F
1
(x
1
), F
2
(x
2
), ..., F
N
(x
N
)) = C(F(x)).
If F
1
, F
2
, . . . , F
N
are continuous, then C is unique. Otherwise C is uniquely
determined on RanF
1
RanF
N
, where RanF
i
denotes the range of
F
i
for i = 1, . . . , N. Thus, for continuous multivariate distributions, the
univariate margins and the dependence structure can be separated. The de-
pendence structure is completely characterised by the copula C. We say that
X
1
, X
2
, . . . , X
N
have a copula C, where C is given by theorem 1. Copula
functions are the most general way to view dependence of random variables.
In particular this concept is much more general than linear correlation which
often fails to capture important risks
1
. Theorem 1 also tells us that the copula
1
See Embrechts et.al. (1999) for more details
5
of X is the distribution function of F
1
(X
1
), . . . , F
n
(X
n
)), and that transfor-
mations of the X
i
do not change the copula as long as all transformations
are monotonous. Independence of continuous random variables is also easily
characterised with their copula: X
1
, X
2
, . . . , X
N
are independent if and only
if the N-dimensional copula C of X
1
, X
2
, . . . , X
N
is
C((F
1
(x
1
), . . . , F
n
(x
n
)) =
N
(F
1
(x
1
), . . . , F
n
(x
n
)).
Example 1 The N-dimensional product copula
N
satises denition 1 and
is given by:

N
(V ) = v
1
. . . v
N
Example 2 (Gaussian copula) Let X
1
, . . . , X
n
be normally distributed ran-
dom variables with means
1
, . . . ,
n
, standard deviations
1
, . . . ,
n
and cor-
relation matrix R. Then the distribution function C
R
(u
1
, . . . , u
n
) of the ran-
dom variables
U
i
:=
_
X
i

i
_
, i n
is a copula and is called the Gaussian copula to the correlation matrix R(where
() denotes the cumulative univariate standard normal distribution func-
tion.)
Example 3 An archimedean copula function C : [0, 1]
n
[0, 1] is a copula
function which can be represented in the following form:
C(x) =
[1]
_
n

i=1
(x
i
)
_
.
with a suitable function : [0, 1] R
+
with (1) = 0, (0) = . The
function : [0, 1] R
+
is called the generator of the copula. Here are
examples of Archimedean copula
(i) The Clayton copula is such that:
(x) = (x

1)
where 0.
(ii) The gumbel copula is such that:
(x) = (ln(x))

where 1
6
2.2 Modelling default times
In the following, we will consider n names with associated random default
times
1
, . . . ,
n
dened on a common probability space (, F, P). We will
denote by t R
+
N
i
(t) = 1
{
i
t}
for i = 1, . . . , n the indicator of default
processes. We will denote by H
i,t
= (N
i
(s), s t) and H
i
will be the natural
ltration of default time
i
, with H = H
i
. In the following, we will consider
reduced-form models of default times dened by :

i
= inf{u R
+
,
_
u
0

i
dv lnU
i
}, i = 1, . . . , n,
where the
i
s are some given F
t
-adapted processes, where F = (F
t
)
tR
+
is some given ltration, and the U
i
are some uniform random variables. In
the following, we will assume independence between F and (U
1
, . . . , U
i
).
This Cox modelling framework for defaults has been introduced by Lando
[1998]. The

i
s represent some marginal default intensities, while the logU
i
can be seen as stochastic barriers. A nice feature of that Cox modelling is
that ltration F possesses the martingale invariance property with respect to
G = F H. For all t 0, for all F

measurable random variable H, E[H |

G
t
] = E[H | F
t
] where G
t
= F
t
H
t
. The martingale invariance property
is aimed at precluding arbitrage opportunities after defaultable securities
are introduced in the market place. Another assessment of the martingale
invariance property is :
P(
1
> t
1
, . . . ,
n
> t
n
| F

) = P(
1
> t
1
, . . . ,
n
> t
n
| F
T
)
for T > 0 and t
1
, . . . , t
n
[0, T].
Some of the models in the literature make the following additional assumption
of conditional independence (with respect to ltration F) :
P(
1
> t
1
, . . . ,
n
> t
n
| F
T
) =
n

i=1
P(
i
> t
i
| F
T
)
for any T > 0 and t
1
, . . . , t
n
[0, T]. Obviously, such assumption is ful-
lled when the U
i
, i = 1, . . . , n are independent and then P(
i
> t
i
| F
T
) =
exp(
_

0

i
(s)ds).
In order to get tractable expressions of basket credit derivatives premiums and
CDO tranches, we will make the assumption that the default times are condi-
tionally independent upon some enlarged lltration where V is G-measurable
random variable. When V is not F

measurable, it can be see as a latent mix-

ing variable corresponding to unobserved random eects. V will thereafter
7
be called the factor. The previous assumption can be written:
P(
1
> t
1
, . . . ,
n
> t
n
| F
T
(V )) =
n

i=1
P(
i
> t
i
| F
T
(V ))
for any T > 0 and t
1
, . . . , t
n
[0, T].
8
3 Factor models
3.1 One factor gaussian copula
The Gaussian Copula has been introduced by Li [1999, 2000] for the pricing
of basket credit derivatives and corresponds to the dependence structure un-
derlying CreditMetrics. We consider hereafter a particular case with a one
factor representation. Let (X
1
, , X
n
) be a gaussian vector, in a one factor
model we write X
i
=
i
V +
_
1
2
i

V
i
, where V and

V
i
, i = 1, , n are inde-
pendent standard Gaussian random variables.We get readily the conditional
default probability
p
i|V
(t) = P(
i
t|V = v)
=
_

1
(F
i
(t))
i
v
_
1
2
i
_
where stands for the standard normal distribution and F
i
the marginal
distribution of the name i. The times of default conditionnally on V are
independent.
3.2 One factor archimedean copula
Let f be the density of a positive mixing variable and (s) =
_

0
e
sv
f(v)dv,
the laplace transform of f. We dene G
i
as t 0, G
i
(t) = exp(
1
(F
i
(t)))
where F
i
is the cdf (cumulative distribution function) of default time
i
. G
i
denes a distribution function and F
i
(t) = (lnG
i
(t)) =
_

0
G
v
i
(t)f(v)dv.
Conditionally on V the distribution of
i
is G
v
i
p
i|V
(t) = exp
_
V
1
(F
i
(t))
_
A typical example is the clayton copula, where the mixing variable V has a
Gamma distribution with parameter 1/, where > 0. More precisely we
have f(x) =
1
(1/)
e
x
x
(1)/
,
1
(s) = s

1
9
4 Basket of credit derivatives
For a basket of credit derivatives we dene a rst-to-default(FtD) swap which
is an extension of a credit default swap to portofolio credit risk. Its key
characteristics are the following:
A rst-to-default is specied with respect to a basket of a reference
credits C
1
, . . . , C
n
.
The set of reference credit assets(the assets that can trigger defaul
events) contains assets by all reference credits.
The protection buyer pays a regular fee to the protection seller when a
default occurs or the FtD matures.
The default event is the rst default of any of the reference credits.
The FtD is terminated after the rst default event.
The default payment is 1-recovery on the defaulted obligor. If physical
delivery is specied, the set of deliverable contains only obligations of
the defaulted reference credit.
A natural extention of the rst-to-default concept is the introduction of
second-to-default(StD) and nth-to-default (ntD) basket credit derivatives.
4.1 Number of defaults distribution
4.1.1 Getting the distribution of k-th-to-default by the semi-explicit
formula
We denote the counting process associated with the number of defaults by
N(t) =

n
i=1
1
{
i
t}
, N(t) =

n
i=1
N
i
(t) where N
i
(t) = 1
{
i
t}
. Lets now
compute the moment generating function

N(t)
(u) = E(u
N(t)
) =
n

k=0
P(N(t) = k)u
k
We get E[u
N
i
(t)|V ] = q
i|V
(t) +up
i|V
(t) where q
i|V
(t) and p
i|V
(t) are the con-
ditional marginal survival and default probabilities. By iterated expectation
theoerem and the independence of N
i
(t) conditionally on V , we get

N(t)
(u) = E
_
n

i=1
(q
i|V
(t) +up
i|V
(t))
_
=
_
n

i=1
_
q
i|V
(t) +up
i|V
(t)
_
f(v)dv
where f is the standard normal density. Since
N(t)
(u) can be written as
E (
0
(V ) +
1
(V )u + +
n
(V )u
n
) .
10
After a formal expansion of E(

n
i=1
(q
i|V
(t) + up
i|V
(t))) and comparing the
two expressions we get P(N(t) = k) = E[
k
(V )] =
_

k
(v)f(v)dv. Theses
expressions are called the semi-explicit expressions.
For dierent models we just have to plug p
i|V
(t) in the formula. The formal
expansion approach is well suited for small values of N, for large values of
N, we have to use the FFT approach.
4.1.2 The fast fourier transform
First we need to compute the characteristic function, we get it by replacing u
by e
is
in the moment generating function and using the independence upon
V .

N(t)
(u) = E(e
iuN(t)
) =
_
n

i=1
_
q
i|V
(t) +e
iu
p
i|V
(t)
_
f(v)dv
By inverting the characteristic function using the FFT, one gets the distri-
bution of N(t), it is very useful when n is large.
4.2 Explicit Survival distribution of the rst-to-default
As a direct consequence of the iterated expectation thereom, we can write
the distribution function of rst-to-default as
S
1
(t) = P(
1
> t) = P(
1
> t, . . . ,
n
> t)
=
_
n

i=1
q
i|V
(t)f(v)dv
4.3 Survival distribution of the k-th to default time
We denote by
k
the time of the k-th default and by S
k
(t) = P(
k
> t),
and F
k
(t) = 1 S
k
(t) the corresponding survival and default distribution
functions. We can write
P(
k
> t) = P(N(t) < k) =
k1

i=0
P(N(t) = i)
which involves only the known P(N(t) = k), k = 1, . . . , n.
11
4.4 Pricing basket of credit derivatives
We consider thereafter the pricing of basket credit derivatives. In a rst-to-
default swap, there is a default payment at the rst to default time. The
payment corresponds to the non recovered part of bond in default.
4.4.1 Pricing the premium leg of k-th-to-default time
We consider here a basket credit derivatives on a set of n reference credits,
with protection payment arising in default. We denote by t
i
, i = 1, . . . , I the
premium payments dates (with t
I
= T where T is the maturity date of the
basket credit derivatives) and by s the periodic premium.
i1,i
represents the
length of the interval [t
i1
, t
i
] and B(t
i
) is the discount factor for maturity t
i
.
For simplicity, we do not take into account accrued premium payments due
to defaults between premium payments dates. From the distribution function
of N(t) we can compute the premium payment. The discounted expectation
of premium payment of date t
i
can then be written as:

i1,i
sB(t
i
)P(N(t
i
< k)
where the probabilities of k names being in default at time t, P(N(t) =
k) have already been computed. We can eventually write the price of the
premium payment leg by summing over possible premium payment dates:
I

i=1

i1,i
sB(t
i
)P(N(t
i
) < k) =
I

i=1
k1

l=0

i1,i
sB(t
i
)P(N(t
i
= l)
4.4.2 Pricing the default leg of the k-th to default time
Let us now consider the default payment leg of a homogeneous basket credit
derivatives: we denote by 1, the nominal of a given reference credit and by R
the unique recovery rate. We will consider the default payment at the date

k
provided that the date is before the maturity of the basket default swap
T = t
I
. Then, we simply have to compute the current price of a k-th to
default payment. We remark that the corresponding discounted payo can
be written as (1 R)1
[0,T]
(
k
)B(
k
) where B(t) denotes the discount factor
for maturity t. Under the previous independence assumptions on interest
rates and recovery rates, we can then write the price of the k-th to default
payment leg as:
E[(1 R)1
[0,T]
(
k
)B(
k
)] = (1 R)
_
T
0
B(t)dS
k
(t)
12
Integrating by parts, we can write the price of the payment leg of the k-th-
to-deafault time as:
(1 R)(1 S
k
(T)B(T) +
_
T
0
S
k
(t)dB(t))
Assuming the deterministic interest rate r as deterministic, we get
(1 R)(1 S
k
(T)B(T) r
_
T
0
e
rt
S
k
(t)d(t)) (1)
4.4.3 Example
(Gaussian Copula) Here are the results of the semi-explicit expressions ap-
proach. Premiums in basis points per annum as a function of correlation for
a 5-year maturity basket with default intensities of [25, 50, 100, 150, 250, 500]
bps and equal recovery rates of 40% are displayed in the following table.
Correlation Semi-explicit
1rst 2nd 3rd
0 730 108 6
10% 725 110 16
20% 711 116 19
30% 653 124 20
40% 624 135 27
50% 613 147 40
60% 564 158 52
70% 507 168 66
80% 445 173 82
90% 376 175 98
4.4.4 Example
(Gaussian Copula and Monte Carlo simulations) A 10000 Monte Carlo sim-
ulations is performed. Premiums and 95% condence interval in basis points
per annum as a function of correlation for a 5-year maturity basket with de-
fault intensities of [25, 50, 100, 150, 250, 500] bps and equal recovery rates of
40% are displayed in the following table.
13
Correlation Monte Carlo simulations
1rst lb rb
0 691.45 691.45 691.45
10% 689.59 682.34 696.84
20% 704.18 688.71 719.66
30% 717.16 692.18 742.18
40% 792.05 745.43 838.67
50% 957.02 811.74 1102
60% 971.47 874.46 1068
70% 2722 1122 4324
The Monte Carlo simulations seems not to be steady for high value of rho.
In the following table we compare the premiums of the clayton copula with
the gaussian copula as a function of the rank of the defaults for the example
described above. For the Gaussian copula model, we have set the correlation
parameter to 30% and for the Clayton copula model, the dependence param-
eter is = 0, 058. This parameter is set in order to have the same rst to
default swap premium when n = 6.
Rank Clayton Gaussian
1 686 687
2 205 125
3 135 23
4 128 8
5 127 7
6 127 6
5 Hedging of credit derivatives basket
On the one hand in this factor framework we compute numerical sensitivities
with respect to shifts in default intensities of 10 bps by the semi-explicit
expressions
(S(V, + ) S(V, ))/
where S(V, ) denotes the spread. On the other hand we compute numerical
sensitivities with respect to shifts in default intensities of 10 bps applying the
indirect Monte carlo method.
N

i=1
(S(V
i
, + ) S(V
i
, ))/
14
where V
i
are generated by Monte Carlo simulations. In our example described
above where premiums in basis points per annum are a function of correlation
for a 5-years maturity basket with default intensities of [25, 50, 100, 150, 250, 500]
bps and equal recovery rates of 40%. The values of the numerical sensitivity
are 1.6 in monte carlo method and 1.59 when applying the indirect monte
carlo method whereas its value is 3 for the semi-explicit formula.
15
6 CDO(collateralised debt obligation)
6.1 Denition
In its simplest, unfunded form, a credit basket or synthetic CDO is a tranche
structure on a portfolio of credit default swaps. The investor, or protection
seller, promises to cover the range of collateral losses dened by a particu-
lar tranche, and receives periodic premium payments in exchange. Various
structures for funding a synthetic CDO are possible; since they do not aect
how we model the collateral pool.
The payments are typically expressed as a percentage of the tranche notional.
Percentage is promised, and premium payments are made, over a specied
time period, referred to as the life of the deal. For simplicity, we assume that
losses and premiums are paid one the same payment dates.
We nd todays markt-to-market value of a tranche as follows. By modelling
the collateral, we estimate the losses we expect the tranche to sustain over the
life of the deal, and discount thoses to today. We also estimate the premium
payments we expect the tranche will receive, and discount those to today as
well. Each expected premium payment is the product of the spread and the
the amount of notional the tranche is still covering on the payment date, and
it therefore also depends on the loss distribution.
We obtain the mark-to-market value of the tranche (from the protection
sellers point of view) by substracting the sum of the discounted expected
losses from sum of the discounted expected premium payments. We dene
the fair spread of the tranche at any time as the spread that would make
the mart-to-market value zero at that time. Througout this paper, we follow
market convention and state price information in terms of spread.
6.2 Calculating the loss distribution
We consider a synthetic CDO with some given maturity T. This is based
upon n reference credits, j = 1, . . . , n, with nominals N
i
, i = 1, . . . , n and
maturity also equal to T. R
j
denotes the recovery rate for credit j and
M
j
= (1 R
j
)N
j
the corresponding loss given default. As above, we denote
by
j
the default time of name j and by N
j
(t) = 1

j
t
the corresponding
counting process. L(t) will denote the cumulative loss on the credit portfolio
at time t:
16
L(t) =
n

j=1
M
j
N
j
(t).
which is also a pure jump process. As a starting point, we compute the char-
acteristic function of the cumulative losses ,
L(t)
(u) = E[exp(iuL(t))]. We
assume conditional independence of default times upon factor V . We more-
over assume that the -algebras (R
1
), . . . , (R
n
) and (V,
1
, . . . ,
n
) are
independent. We can write from iterated expectations theorem:
L(t)
(u) =
E[E[exp(iuL(t)) | V ]]. From the independence of N
i
(t) conditionally on V
and the independence assumption over the recovery rates, we get
E[exp(iuL(t)) | V ] =
n

j=1
E[exp(iuM
j
N
j
(t)) | V ].
This gives
E[exp(iuL(t)) | V ] =
n

j=1
(q
j|V
t
+p
j|V
t

1R
j
)
where p
j|V
t
and q
j|V
t
are the conditional default and survival probabilites and

1R
j
denotes the characteristic function of 1 R
j
. This leads to:

L(t)
(u) =
_
n

j=1
(q
j|V
t
+p
j|V
t

1R
j
(uN
j
)f(v)dv
6.3 Pricing Formulas and Simple Consequences
We expand the discussion of how to use the collateral loss distributions to
price the tranche, and point out some simple consequences.
Let t
i
denote the i-th payment date. Let L
i
represent the total collateral
loss the tranche has sustained by date t
i
, and let P
i
represent the premium
payment the tranche receives on date t
i
, we can write P
i
= s N
i
, where s is
the spread the tranche receives, and N
i
is the amount of notional on which
the i-th payment is based.
Both L
i
and N
i
depend on the total credit losses the portfolio sustains by
time t
i
. this is evident for the tranche loss L
i
. For the tranche notional N
i
,
there are two conventions:
17
(1) Risk-free payments. The tranche receives full premiums until it is wiped
out. Thus if N
0
is the initial notional of the tranche, we have N
i
= N
0
if L
i
< N
0
, and N
i
= 0 otherwise.
(2) Risk payments. Each premium is a coupon on the remaning collateral
of the tranche, after credit losses. Thus, N
i
= N
0
L
i
. In the following,
we study a deal with risk payments.
Our methodology works for both conventions, because either way, we can
compute the payment from the spread and the total credit loss sustained by
the payment date. More precisely, if we know the portfolio loss distribution,
we can compute the distrbution of L
i
and of N
i
, and the expectations E(L
i
)
and E(N
i
).
At time t
i
, the tranche receives a premium payment of sN
i
, and pays L
i
L
i1
(new losses sustained since the last payment date) to cover losses. Denoting
the discount factor to time t
i
by D
i
, we nd that the expectation of the sum
of the discounted premium payment is
Total Expected Payments = s

i
D
i
.E(N
i
)
and that the expectation of the sum of the disconted losses is
Total Expected Losses = s

i
D
i
(E(L
i
) E(L
i1
))
Thus, the mark-to-market is given by
Mark-to-Market =

i
D
i
(s E(N
i
) E(L
i
) +E(L
i1
))
The fair spread s
f
makes the mark-to-market equal to 0. In other words,
s
f
=

i
D
i
(E(L
i
) E(L
i1
))

i
D
i
E(N
i
)
7 Conclusion
From the factor approach which implies the independence of default times
over V , we can get tractable expressions for the pricing of basket credit
derivatives and synthetic CDO premiums. Moreover this enables comparison
when pricing under the Clayton and Gaussian Copula.
18
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