Consistent Valuation of Bespoke CDO Tranches

TL;DR

This paper introduces a consistent, arbitrage-free multi-factor pricing model for bespoke CDO tranches that improves upon existing methods by explicitly modeling market factor correlations and using efficient semi-analytical Monte Carlo techniques.

Contribution

It extends the Li 2009 model to a multi-factor framework, addressing flaws in the standard base correlation mapping approach for bespoke CDO tranche valuation.

Findings

Prices align with standard base correlation methods

Efficient semi-analytical Monte Carlo reduces computation time

Model handles practical issues like deltas and quanto adjustments

Abstract

This paper describes a consistent and arbitrage-free pricing methodology for bespoke CDO tranches. The proposed method is a multi-factor extension to the (Li 2009) model, and it is free of the known flaws in the current standard pricing method of base correlation mapping. This method assigns a distinct market factor to each liquid credit index and models the correlation between these market factors explicitly. A low-dimensional semi-analytical Monte Carlo is shown to be very efficient in computing the PVs and risks of bespoke tranches. Numerical examples show that resulting bespoke tranche prices are generally in line with the current standard method of base correlation with TLP mapping. Practical issues such as model deltas and quanto adjustment are also discussed as numerical examples.