Comparing Some Alternative Lévy Base Correlation Models for Pricing and Hedging Cdo Tranches

In this paper we investigate alternative Lévy base correlation models that arise from the Gamma, Inverse Gaussian and CMY distribution classes. We compare these models to the basic (exponential) Lévy base correlation model and the classical Gaussian base correlation model. For all the investigated models, the Lévy base correlation curve is significantly flatter than the corresponding Gaussian one, which indicates better correspondence of the Lévy models with reality. Furthermore, we present the results of pricing bespoke tranchlets and comparing deltas of both standard and custom-made tranches under all the considered models. We focus on deltas with respect to CDS index and individual CDS, and the hedge ratio for hedging the equity tranche with the junior mezzanine. K.U.Leuven EURANDOM, P.O.Box 513, 5600 MB Eindhoven, The Netherlands. E-mail: [email protected] K.U.Leuven, Department of Mathematics, Celestijnenlaan 200 B, B-3001 Leuven, Belgium. E-mail: [email protected]