Binomial Approximation to Locally Dependent CDO

TL;DR

This paper introduces a Stein's method-based binomial approximation for locally dependent CDOs, providing sharper error bounds than existing methods, with applications to independent CDOs.

Contribution

It develops a novel Stein's method approach for binomial approximation in the context of locally dependent CDOs, improving error bounds.

Findings

Sharper bounds than existing methods.

Applicable to both dependent and independent CDOs.

Provides a framework for error estimation in financial models.

Abstract

In this paper, we develop Stein's method for binomial approximation using the stop-loss metric that allows one to obtain a bound on the error term between the expectation of call functions. We obtain the results for a locally dependent collateralized debt obligation (CDO), under certain conditions on moments. The results are also exemplified for an independent CDO. Finally, it is shown that our bounds are sharper than the existing bounds.