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Credit Risk Frontiers: Subprime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity by Frédéric Patras, Damiano Brigo, Tomasz R. Bielecki

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Chapter 4

A Simple Dynamic Model for Pricing and Hedging Heterogeneous CDOs

Andrei V. Lopatin

Numerix LLC

We present a simple bottom-up dynamic credit model that can be calibrated simultaneously to the market quotes on collateralized debt obligation (CDO) tranches and individual credit default swaps (CDSs) constituting the credit portfolio. The model is most suitable for the purpose of evaluating the hedge ratios of CDO tranches with respect to the underlying credit names. Default intensities of individual assets are modeled as deterministic functions of time and the total number of defaults accumulated in the portfolio. To overcome numerical difficulties, we suggest a semianalytic approximation that is justified by the large number of portfolio ...

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