Dynamic implied correlation modeling and forecasting in structured finance

Publisher:
Wiley
Publication Type:
Journal Article
Citation:
Journal of Futures Markets, 2013, 33 (11), pp. 994 - 1023
Issue Date:
2013-01
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Correlations are the main drivers for credit portfolio risk and constitute a major element in pricing credit derivatives such as synthetic single-tranche collateralized debt obligation swaps. This study suggests a dynamic panel regression approach to model and forecast implied correlations. Random effects are introduced to account for unobservable time-specific effects on implied tranche correlations. The implied-correlation forecasts of tranche spreads are compared to forecasts using historical correlations from asset returns. The empirical findings support our proposed dynamic mixed-effects regression correlation model.
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