Correlation Risk Modelling and Management (2nd Edition)
First published:
ISBN: 978-1-78272-405-6
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Valuing CDOs with the Gaussian Copula – What Went Wrong?
Introduction
Correlation Basics: Definitions, Applications and Terminology
Empirical Properties of Correlation: How do Correlations Behave in the Real World?
The Pearson Correlation Model – Work of the Devil?
Cointegration – A Superior Concept to Correlation?
Financial Correlation Modelling – Bottom-up Approaches
Valuing CDOs with the Gaussian Copula – What Went Wrong?
The One-Factor Gaussian Copula Model – Too Simplistic?
Financial Correlation Models – Top-Down Approaches
Stochastic Correlation Models
Quantifying Market Correlation Risk
Quantifying Credit Correlation Risk
Hedging Correlation Risk
Correlation Trading Strategies – Opportunities and Limitations
Credit Value at Risk under Basel III – Too Simplistic?
Basel III and XVAs
Fundamental Review of the Trading Book
The Future of Correlation Modelling
Answers to Questions and Problems in Correlation Risk Modelling and Management
“Take risks: if you win, you will be happy; if you lose, you will be wise”
– author unknown
When the global financial crisis hit from 2007 to 2009, the Gaussian copula was widely blamed for the crisis, especially when applied to valuing collateralised debt obligations (CDOs).11 See “Recipe for Disaster: The Formula that killed Wall Street”, Wired (2009); “Wall Street Wizards Forgot a Few Variables”, New York Times (2009); “The formula that felled Wall Street”, Financial Times (2009). In this chapter we analyse the pricing methodology of CDOs and evaluate whether the Gaussian copula is to blame. Let’s first look at some CDO basics.
CDO BASICS – WHAT IS A CDO? WHY CDOS? TYPES OF CDOS What is a CDO?
A CDO (collateralised debt obligation) is a financial structure in which the credit risk from a pool of securities is transferred from one counterparty, the originating bank, to another, the investor. The investor can invest money in different CDO tranches. Each tranche has a different degree of credit risk. The credit risk is distributed with a waterfall principle: if losses accumulate and the detachment level of a tranche is breached, additional credit losses flow into the
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