A bottom-up model with top-down dynamics

Yadong Li proposes a flexible, tractable and arbitrage-free bottom-up dynamic correlation modelling framework with a consistent stochastic recovery specification for multi-name credit derivatives. In this framework, the model’s spread dynamics can be changed separately from the loss distribution and tranche prices by applying existing top-down methods to the common factor process

The recent volatility in the synthetic collateralised debt obligation (CDO) market underscores the need for more consistent models beyond the standard base correlation model, whose drawbacks are well understood and documented. Much effort has been devoted to the development of proper dynamic correlation models.

There are two main types of dynamic correlation models in the literature: the top-down approach (for example, Sidenius, Piterbarg & Andersen, 2006, and Schonbucher, 2006) and the bottom