Risk-neutral correlations in the pricing and hedging of basket credit derivatives

Michael B. Walker

Abstract

ABSTRACT

Whereas a widely held current view is that the correlation parameters arising in the risk-neutral procedure for the pricing of basket credit derivatives should, at least in principle, be set equal to their real-world values obtained from historical data, the conclusion of this article is that the correlation parameters are risk-neutral parameters with a range of allowable values. As a result, buyers and sellers of basket credit derivatives have a wide range of arbitrage-free prices to choose from, and it is the market, not risk-neutral pricing, that determines, both in principle and in practice, a definite price.