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A Consistent Approach to the Term Structure of Correlation

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Common market best practice for pricing off-the-run or bespoke collateralized debt obligation tranches involves mapping implied base correlation surfaces calibrated from actively traded tranches such as those on the CDX or iTraxx.

Over the last few years, research in this area has resulted in a constant stream of improvements and refinements of this process. The term structure approach for base correlation surfaces is an important incremental improvement over commonly used methods for dealing with the maturity dimension of base correlation surfaces.

In particular, a plethora of new methods for mapping attachment and detachment points have evolved, each with particular strengths and weaknesses. All these approaches are incremental improvements on the original method of mapping the expected loss of a bespoke tranche to the matching base correlation of a standard tranche with the same expected loss. This allows base correlations to be applied to portfolios that differ from that of the standard tranches. The success of the mapping depends on how similar in certain dimensions the bespoke portfolio is to that of the standard tranche and how sophisticated the mapping process.

The term structure approach for base  correlation surfaces is an important incremental improvement over commonly used methods for dealing with the maturity dimension of base correlation surfaces.  It is particularly important for longer dated equity and junior mezzanine tranches in environments where the correlation term structure is steep.

 

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