QMF Sydney — December 13, 2006

STCDO Model Calibration and

Hedge Performance
fabian_vieth@westlb.com
Outline
„ Single Tranche CDOs

„ The Standard Market Model

„ Normal Inverse Gaussian Model

„ Base Correlation Curves

„ Delta Hedging STCDOs

WestLB AG STCDO Model Hedge Performance

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Single Tranche CDO (STCDO)
Product Description

Credit Risk Transfer

Premium
Protection Buyer Protection Seller
Reference Portfolio $1 Billion
3%-7%Tranche
Protection covers losses
Tranche size $40 Million
between 3%–7%
Payment if the loss exceeds
the subordination level, capped
by the tranche size

ƒ Financial contract between two parties that references a portfolio of credits.

ƒ Tranche covers losses from the attachment point a to the detachment point d.
ƒ Floating leg of the swap pays out all portfolio losses that take place inside [a, d].
ƒ Fixed leg of the swap pays a premium on the remaining notional of the tranche.
ƒ Contract terminates at the stated maturity date or if losses ≥ tranche notinal.

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Single Tranche CDO (STCDO)
Pricing – Floating Leg

E⎜ ∫ P(0, t )dL[ a ,d ] (t ) ⎟ = ∫ P(0, t ) E (dL[ a ,d ] (t ) )

⎛ ⎞
T T

⎝ 0 ⎠ 0

P is the riskfree discount factor, L[]a,d] is the loss distribution for a tranche from a to b.
Can discretize on some time grid e.g. fixed leg coupon payment dates

⎛ T j + T j −1 ⎞
⎟⎟ E (L[ a ,d ] (T j ) − L[ a ,d ] (T j −1 ) )
S
≈ ∑ P⎜⎜ 0,
j =1 ⎝ 2 ⎠
⎛ T j + T j −1 ⎞
[ ]
⎟⎟ E (L[ a ,d ] (T j ) ) − E (L[ a ,d ] (T−1 j ) )
S
= ∑ P⎜⎜ 0,
j =1 ⎝ 2 ⎠

L[ a ,d ] (T j ) = (L(T j ) − a ) − (L(T j ) − d )
+ +

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Single Tranche CDO (STCDO)
Pricing – Fixed Leg

As before, we discretize on some time grid e.g. fixed leg coupon payment dates

c ∑ P (0, T j )δ j [ ]
S
1
E N[ a ,d ] (T j ) + E N[ a ,d ] (T j − 1)
j =1 2
where c is the tranche coupon, and N[ a ,d ] (t ) = (d − a) − L[ a ,d ] (t )

As before, this equation is linear in the various L[]a,d](Tj).

Hence, if we know the distribution of L(Tj) for all Tj we can price the CDO tranche.

WestLB AG STCDO Model Hedge Performance

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The Standard Market Model
„ Guassian Copula Model
ƒ Dependence among default times of different credits is determined by
dependence structure (i.e. copula) of the latent variables.
ƒ Most popular latent variable model combines Gaussian copula with one-factor
correlation framework.
ƒ Return of asset i, Xi, driven by market factor, M, and idiosyncratic factor εi :

X i = β i M + 1− β i2 ε i (1)

ƒ M and εi are iid standard normals. Thus, Xi are jointly normal with pairwise
correlations:
ρ ij = Corr ( X i , X j ) = β i β j
ƒ In the following, we use the same correlation for all credits i.e.

β i = β ∀i and thus ρ = ρ ij = β ∀i
2

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The Standard Market Model
„ Guassian Copula Model

ƒ Conditionally on M, the Xi are independent. Thus, the probability that credit i

defaults before time T given M=m is:
⎛ K (T ) − β M ⎞
P(τ i ≤ Ti | M = m) = P( X i ≤ K i (T ) | M = m) = Φ⎜ i ⎟ (2)
⎜ − β 2 ⎟
⎝ 1 ⎠
where Ki(T) = Φ -1(pi(T)) is the default threshold for a given time horizon, T,
calibrated to the credit curve.

ƒ The conditional distribution of losses over some time interval [0, T] follows
from a simple recursion. See Andersen et al (2003).

ƒ The unconditional loss distribution can be recovered by numerically

integrating out the dependence on M.

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The STCDO Market
„ Base Correlation Skew

WestLB AG STCDO Model Hedge Performance

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The STCDO Market
„ Base Correlation through Time

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Normal Inverse Gaussian (NIG) Model
„ 1-Factor NIG Model

ƒ As before in the Gaussian case, we use a one-factor correlation matrix.

ƒ The idiosyncratic components are assumed normal, again. But now the
systematic factor is NIG distributed.
ƒ Return of asset i, Xi, is driven by market factor, M, and idiosyncratic factor εi :

X i = β i M + 1− β i2 ε i
ƒ εi are iid standard normals and M is NIG distributed with zero mean and unit
variance, and uncorrelated with the εi.

ƒ As in the Gaussian case, the correlation between credits i and j is

ρ ij = Corr ( X i , X j ) = β i β j
ƒ In the following, we use the same correlation for all credits i.e.
β i = β ∀i and thus ρ = ρ ij = β 2
∀i

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Normal Inverse Gaussian (NIG) Model
„ Some References to other NIG Papers

ƒ Guegan, D., Houdain, J. (2005). Collateralized Debt Obligations pricing and

factor models: a new methodology using Normal Inverse Gaussian
distributions. Note de Recherche IDHE-MORA n007-2005.

ƒ Kalemanova, A., Schmid, B. and Werner, R. (2005). The normal inverse

Gaussian distribution for synthetic CDO pricing. Working paper, risklab
germany.

ƒ Lüscher, A. (2005). Synthetic CDO pricing using the double normal inverse
Gaussian copula with stochastic factor loadings. Diploma thesis ETH Zurich.

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Normal Inverse Gaussian (NIG) Model
„ The NIG Distribution

ƒ The NIG distribution is a subclass of the Generalizes Hyperbolic Distributions

ƒ The density is given by
⎛ ⎛ x − μ ⎞ ⎞⎟
2
⎜
K1 α 1 + ⎜ ⎟ ⎟
⎛ ⎞ ⎝ ⎜ ⎝ δ ⎠ ⎠
α 2 x−μ
exp⎜⎜ α −β
2
⎟
δπ ⎝ δ ⎟⎠ ⎛ x−μ ⎞
2

1+ ⎜ ⎟
⎝ δ ⎠
0 ≤ δ and 0 ≤ β ≤ α
where K1 is the modified Bessel function of the third kind
1 ∞ ⎛ 1 ⎞
K1 ( w) := ∫ exp⎜ − w(t + t −1 ) ⎟ dt
2 0 ⎝ 2 ⎠

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Normal Inverse Gaussian (NIG) Model
„ Moments of the NIG Distribution

The moments of a random variable X ~ NIG (α , β , μ , δ ) are

1
Mean m=μ+β
ζ
α2
Variance v =
δζ 3

3β
Skew s=
α ζ 3/ 2

⎛ α 2 + 4β 2 ⎞
Kurtosis k = 3⎜1 + ⎟⎟
⎜ α ζ ⎠
2
⎝

where ζ = α 2 −β 2

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Normal Inverse Gaussian (NIG) Model
„ Model Parameters

NIG1 NIG2 NIG3 NIG4

alpha 0.3050 0.2000 0.1700 0.1000
beta 0.0666 0.0650 0.0270 0.0050
mu (0.1191) (0.1413) (0.0651) (0.0158)
delta 0.5324 0.4113 0.4045 0.3156

skew 1.20 2.24 1.16 0.47

kurtosis 15.00 25.56 22.68 33.34

NIG1 parameters taken from 5 year calibration in Geugan and Houdain (2005). They
calibrate to iTraxx Series 3 on 18-Apr-05, assuming a flat correlation of 20%.

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Normal Inverse Gaussian (NIG) Model
„ Probability Density Functions

1.2

1.0

0.8
NIG1
NIG2
0.6 NIG3
NIG4
Gauss
0.4

0.2

0.0
-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0

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Normal Inverse Gaussian (NIG) Mode
„ Probability Density Functions Log Scale

1.0E+01

1.0E+00

1.0E-01

1.0E-02
NIG1
1.0E-03 NIG2
NIG3
1.0E-04 NIG4
Gauss
1.0E-05

1.0E-06

1.0E-07

1.0E-08
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0

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Normal Inverse Gaussian (NIG) Model
„ Probability Density Functions Log Scale

1.0E+01

1.0E+00

NIG1
1.0E-01
NIG2
NIG3
NIG4
1.0E-02
Gauss

1.0E-03

1.0E-04
-5.0 -3.0 -1.0 1.0 3.0 5.0

WestLB AG STCDO Model Hedge Performance

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Normal Inverse Gaussian (NIG) Model
„ Base Correlation Skew CDX6 NIG1

20.0%

18.0%

31-Mar-06

16.0% 28-Apr-06
31-May-06
30-Jun-06
14.0% 31-Jul-06
31-Aug-06
29-Sep-06
12.0%
31-Oct-06
10-Nov-06

10.0%

8.0%
3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Normal Inverse Gaussian (NIG) Model
„ Base Correlation Skew CDX6 NIG2

15.0%

14.0%

13.0%
31-Mar-06
12.0% 28-Apr-06
31-May-06
11.0%
30-Jun-06
10.0% 31-Jul-06
31-Aug-06
9.0%
29-Sep-06

8.0% 31-Oct-06
10-Nov-06
7.0%

6.0%

5.0%
3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Normal Inverse Gaussian (NIG) Model
„ Base Correlation Skew CDX6 NIG3

17.5%

16.5%

15.5%
31-Mar-06

14.5% 28-Apr-06
31-May-06
13.5% 30-Jun-06
31-Jul-06
12.5% 31-Aug-06
29-Sep-06
11.5% 31-Oct-06
10-Nov-06
10.5%

9.5%

8.5%
3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Normal Inverse Gaussian (NIG) Model
„ Base Correlation Skew CDX6 NIG4

17.5%

16.5%

15.5%
31-Mar-06
14.5% 28-Apr-06
31-May-06
13.5%
30-Jun-06
12.5% 31-Jul-06
31-Aug-06
11.5%
29-Sep-06

10.5% 31-Oct-06
10-Nov-06
9.5%

8.5%

7.5%
3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Gaussian Copula Model
„ Base Correlation Skew CDX6 Gaussian Copula

68.0%

58.0%
31-Mar-06
28-Apr-06
48.0% 31-May-06
30-Jun-06
31-Jul-06
38.0%
31-Aug-06
29-Sep-06
28.0% 31-Oct-06
10-Nov-06

18.0%

8.0%
3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Model Comparison
„ Base Correlation Skew CDX6

Minimum Base Correlation (30-Mar-2006 to 10-Nov-2006)

3% 7% 10% 15% 30% 55%
Gauss
NIG1
49%
Gauss 8.6% 21.6% 28.7% 38.3% 58.6% 43%
NIG2
NIG3

NIG1 9.0% 10.4% 10.2% 10.0% 7.3% 37%

31%
NIG4

NIG2 9.1% 8.6% 7.9% 7.0% 4.5% 25%

19%
NIG3 8.3% 8.8% 8.9% 9.2% 8.4% 13%
7%
NIG4 7.5% 7.6% 8.0% 9.0% 10.9% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

Maximum Base Correlation (30-Mar-2006 to 10-Nov-2006)

70%
3% 7% 10% 15% 30% 64%
Gauss
NIG1
58%
Gauss 14.0% 27.6% 35.5% 47.0% 70.5% 52%
NIG2
NIG3
46%
NIG1 11.7% 15.2% 16.6% 18.2% 19.2% 40%
NIG4

34%
NIG2 12.1% 13.8% 14.2% 14.6% 13.7% 28%
22%
NIG3 11.1% 13.1% 14.2% 15.8% 17.8% 16%
10%
NIG4 10.3% 11.3% 12.3% 14.1% 17.6% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

WestLB AG STCDO Model Hedge Performance

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Delta Hedging
„ Market Standard Delta
ƒ Quoted delta is the amount of index protection (as a multiple of tranche
notional) needed to hedge for a 1 bp shift in the index spread.
ƒ Quoted delta can vary significantly between different dealers

„ Delta Calculation – Index Delta

ƒ We define tranche index delta in our model context by:

δ CDX
Tranche
Δ TrancheCDX =
δ CDX
ƒ where
δ CDX
Tranche
= VTranche ( SCDX + 1 bp, Θ) − VTranche ( SCDX , Θ) = VTranche ( SCDX + 1 bp, Θ)
δ CDX = VCDX ( SCDX + 1 bp) − VCDX ( SCDX )
VCDX(·) and VTranche(·) are the index and tranche pricing functions, respectively.

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Delta Hedging (continued)
In order to evaluate VTranche(SCDX + 1 bp) we need to recalibrate λ such that the
shifted index prices correctly using our CDS term structures.
Thus, index delta is effectively a scenario where all CDS term structures are
multiplied by some factor λ.

„ Delta Calculation – CDS Delta

ƒ We define total tranche CDS delta in our model context by:
δ iTranche
Δ TrancheCDS =
where
∑δ i
i

δ iTranche = VTranche ( Si + 1 bp, Θ)

δ i = Vi ( Si + 1 bp) − Vi ( Si ) = Vi ( Si + 1 bp)
Vi is the price of a single name CDS contract.

WestLB AG STCDO Model Hedge Performance

Structured Credit Trading Page 25
Hedge Results
„ NIG4 Model
0% - 3% Tranche vs. Index
CDX.NA.IG Series 6
$350,000

$250,000
y = -0.93 x
2
R = 93.2%
$150,000
0%-3% Tranche P&L

$50,000

-$50,000

-$150,000

-$250,000

-$350,000
-$350,000 -$250,000 -$150,000 -$50,000 $50,000 $150,000 $250,000 $350,000
Index Hedge P&L

WestLB AG STCDO Model Hedge Performance

Structured Credit Trading Page 26
Hedge Results
„ NIG4 Model
Model Hedge: 10 mio. 0%-3% Tranche vs. CDX 6 Index
30-Mar-06 – 10-Nov-06
$2,000,000 31
Commulative Index Hedge P&L
Total Commulative P&L 30
$1,500,000
Commulative 0%-3% Tranche P&L
29
Delta (right scale)
$1,000,000
28

$500,000
27

$0 26

25
($500,000)

24
($1,000,000)
23

($1,500,000)
22

($2,000,000) 21
4-May-06
11-May-06
18-May-06
25-May-06
30-Mar-06
6-Apr-06
13-Apr-06
20-Apr-06
27-Apr-06

3-Aug-06
10-Aug-06
17-Aug-06
24-Aug-06
31-Aug-06

2-Nov-06
9-Nov-06
1-Jun-06
8-Jun-06
15-Jun-06
22-Jun-06
29-Jun-06
6-Jul-06
13-Jul-06
20-Jul-06
27-Jul-06

7-Sep-06
14-Sep-06
21-Sep-06
28-Sep-06
5-Oct-06
12-Oct-06
19-Oct-06
26-Oct-06
WestLB AG STCDO Model Hedge Performance
Structured Credit Trading Page 27
 Daily P&L

WestLB AG
$5,000
$55,000
$105,000

($95,000)
($45,000)
30-Mar-06
6-Apr-06

Structured Credit Trading

13-Apr-06
„ NIG4 Model
20-Apr-06
27-Apr-06
Hedge Results

4-May-06
11-May-06
18-May-06
25-May-06

1-Jun-06

Page 28
8-Jun-06
15-Jun-06

22-Jun-06
29-Jun-06
6-Jul-06

STCDO Model Hedge Performance

13-Jul-06
20-Jul-06
27-Jul-06
30-Mar-06 – 10-Nov-06

3-Aug-06

10-Aug-06
17-Aug-06
24-Aug-06

31-Aug-06
Model Hedge: 10 mio. 0%-3% Tranche vs. CDX 6 Index

7-Sep-06
14-Sep-06

21-Sep-06
28-Sep-06
5-Oct-06
12-Oct-06

19-Oct-06
26-Oct-06
2-Nov-06

9-Nov-06
 WestLB AG
$0

($400,000)
($350,000)
($300,000)
($250,000)
($200,000)
($150,000)
($100,000)
($50,000)
30-Mar-06

6-Apr-06

Structured Credit Trading

13-Apr-06

NIG1
NIG2
NIG3
NIG4
20-Apr-06

Gauss
„ NIG4 Model

27-Apr-06
Hedge Results

4-May-06
11-May-06

18-May-06
25-May-06

1-Jun-06

Page 29
8-Jun-06

15-Jun-06
22-Jun-06

29-Jun-06
6-Jul-06

13-Jul-06

STCDO Model Hedge Performance

20-Jul-06

27-Jul-06
30-Mar-06 – 10-Nov-06

3-Aug-06

10-Aug-06
17-Aug-06

24-Aug-06
31-Aug-06
Model Hedge: 10 mio. 0%-3% Tranche vs. CDX 6 Index

7-Sep-06
14-Sep-06

21-Sep-06

28-Sep-06
5-Oct-06

12-Oct-06
19-Oct-06

26-Oct-06
2-Nov-06

9-Nov-06
Hedge Results
„ P&L Distribution for Hedged Equity Tranche

50%
Gauss
45%
NIG1
NIG2
40%
NIG3

35% NIG4

30%

25%

20%

15%

10%

5%

0%
($100,000) ($50,000) $0 $50,000 $100,000 $150,000

WestLB AG STCDO Model Hedge Performance

Structured Credit Trading Page 30
Hedge Results
„ Statistics of Hedged Equity Tranche P&L

p&l volatility min max mean median

NIG1 25,013 (75,275) 135,778 (1,282) (2,851)
NIG2 25,266 (84,143) 136,921 (985) (2,069)
NIG3 25,278 (84,341) 136,894 (988) (2,280)
NIG4 25,660 (92,218) 137,820 (733) (2,037)
Gauss 25,701 (66,436) 130,866 (2,379) (3,542)

WestLB AG STCDO Model Hedge Performance

Structured Credit Trading Page 31
Hedge Results
„ NIG4 Model

3% - 7% Tranche vs. Index

CDX.NA.IG Series 6
$110,000

$90,000
y = -1.19 x
$70,000 2
R = 89.4%
$50,000
3%-7% Tranche P&L

$30,000

$10,000

-$10,000

-$30,000

-$50,000

-$70,000

-$90,000
-$90,000 -$70,000 -$50,000 -$30,000 -$10,000 $10,000 $30,000 $50,000 $70,000 $90,000
Index Hedge P&L

WestLB AG STCDO Model Hedge Performance

Structured Credit Trading Page 32
Hedge Results
„ NIG4 Model

Model Hedge: 10 mio. 3%-7% Tranche vs. CDX Index

30-Mar-06 – 20-Nov-06

8.0
$400,000
7.5
$300,000
7.0
$200,000
6.5

$100,000
6.0

$0
5.5

($100,000)
5.0
Commulative Index Hedge P&L
($200,000) 4.5
Total Commulative P&L

($300,000) Commulative 3%-7% Tranche P&L

4.0
Delta
($400,000) 3.5
11-May-06

25-May-06
30-Mar-06

13-Apr-06

27-Apr-06

3-Aug-06

17-Aug-06

31-Aug-06

9-Nov-06
8-Jun-06

22-Jun-06

6-Jul-06

20-Jul-06

14-Sep-06

28-Sep-06

12-Oct-06

26-Oct-06
WestLB AG STCDO Model Hedge Performance
Structured Credit Trading Page 33
Hedge Results
„ Statistics of Hedged Mezzanine Tranche P&L

p&l volatility min max mean median

NIG1 9,967 (36,870) 29,735 629 668
NIG2 9,999 (37,012) 29,761 627 673
NIG3 10,662 (38,236) 31,661 441 736
NIG4 11,487 (39,577) 33,657 249 545
Gauss 10,843 (37,917) 31,961 408 702

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Disclaimer

Unless indicated, the views and opinions expressed in this document are the author’s and may differ from those of WestLB AG.

This material was prepared for information purposes only and is not an offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. This material is based on public information as of the specified date, and may
be stale after such date. WestLB AG has no obligation to tell you when opinions or information in this material change and makes
no representation or warranty with respect to the accuracy or completeness of the information contained herein.

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