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Abstract
The reported ”correlation smile” in the CDO market is proof that the
spreads of CDOs tranches are not consistent when we use the widely-known
Gaussian one-factor model for the pricing. We introduce a new methodology
in which non-standard tranches such as bespoke single tranches can
be valued. The underlying idea of our framework is to use the tranches’
price quotes available in the market to determine the implied distribution
of the common factor for a given correlation level. In our methodology the
estimated correlation between the underlying assets of a CDO’s underlying
portfolio becomes an input. We propose an improvement to the market standard
model by using Normal Inverse Gaussian distributions and we show that
our approach is theoretically and empirically more accurate.
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