Dependent Defaults and Losses with Factor Copula Models

TL;DR

This paper introduces a flexible class of static factor copula models for joint default probabilities, enabling efficient loss distribution computation and fitting credit index tranche prices, with many standard models as special cases.

Contribution

It develops a high-dimensional, parsimonious factor copula framework that encompasses many existing models and allows exact loss distribution calculations for portfolios.

Findings

Models can exactly compute loss distributions for portfolios.

Numerical examples highlight key features affecting credit derivatives.

Empirical fitting of credit index tranche prices demonstrates model flexibility.

Abstract

We present a class of flexible and tractable static factor models for the term structure of joint default probabilities, the factor copula models. These high-dimensional models remain parsimonious with pair-copula constructions, and nest many standard models as special cases. The loss distribution of a portfolio of contingent claims can be exactly and efficiently computed when individual losses are discretely supported on a finite grid. Numerical examples study the key features affecting the loss distribution and multi-name credit derivatives prices. An empirical exercise illustrates the flexibility of our approach by fitting credit index tranche prices.