Let's jump together: pricing credit derivatives

Joao Garcia, Serge Goossens and Wim Schoutens introduce a dynamic multivariate jump-driven model for credit spreads. The model parameters come from a calibration on swaptions and a correlation-matching procedure. The authors apply the model to credit constant proportion portfolio insurance and constant proportion debt obligation (CPDO) structures, and point out that there is significant model risk in earlier valuation strategies, in particular for the CPDO structure

Two recent innovations in the credit derivatives market are constant proportion portfolio insurance (CPPI) and constant proportion debt obligations (CPDOs). The invested capital is put in a risk-free bond and a position is taken on credit derivatives. In CPPI, the principal is guaranteed at maturity and the goal is to maximise the portfolio value. In a CPDO, the target is a significant excess return over the risk-free rate, subject to the constraint of being highly rated.

Essential to the