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Robert Lamb, William Perraudin and Astrid Van Landschoot
This paper applies a new class of dynamic credit loss rate models to the pricing of benchmark synthetic Collateralized Debt Obligations (CDOs). Our approach builds directly on the static, industry-standard, pricing approach to credit structured products based on Vasicek (1991). We generalize the Vasicek model by allowing risk factors to be driven by arbitrarily complex auto-regressive processes. We show how to benchmark our model using CDX prices, and demonstrate that it can consistently and accurately fit the prices of multiple tranches with different subordination levels and tenors. Among other interesting results, we find that changes in tranche spreads are driven less by alterations in the market’s estimate of default correlation (which is stable over time) and more by punctuations in market perceptions of the persistence of credit shocks, i.e., the persistence of the credit cycle.