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arXiv:0809.1393q-fin.CP

Graphical models for correlated defaults

I. Onur Filiz, Xin Guo, Jason Morton, Bernd Sturmfels

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Abstract

A simple graphical model for correlated defaults is proposed, with explicit formulas for the loss distribution. Algebraic geometry techniques are employed to show that this model is well posed for default dependence: it represents any given marginal distribution for single firms and pairwise correlation matrix. These techniques also provide a calibration algorithm based on maximum likelihood estimation. Finally, the model is compared with standard normal copula model in terms of tails of the loss distribution and implied correlation smile.

arXiv comments
30 pages, 16 figures
Journal reference
DOI
Subjects
q-fin.CPComputational Finance math.PRProbability q-fin.RMRisk Management q-fin.STStatistical Finance

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  1. The math that killed Lehman Brothers 1 comment

    • I agree. And allow me to suggest this paper: http://arxiv.org/abs/0809.1393 It's not everyday that you see an algebraic geometer writing on CDOs ;-)

      TriinTView on HNParent context

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