RT Journal Article
SR Electronic
T1 The One-Factor Gaussian Copula Applied To CDOs
JF The Journal of Structured Finance
FD Institutional Investor Journals
SP 60
OP 71
DO 10.3905/jsf.2007.698656
VO 13
IS 3
A1 Arturo Cifuentes
A1 Georgios Katsaros
YR 2007
UL https://pm-research.com/content/13/3/60.abstract
AB The one-factor Gaussian copula method has become the de facto standard to analyze most synthetic collateralized debt obligation structures. Unfortunately, this method produces a peculiar phenomenon known as a correlation smile (the implied correlation determined by the model depends on the CDO tranche one is considering instead of being tranche-independent). Market participants are divided regarding this issue. Many suspect that the correlation smile is caused by a flaw in the above-mentioned modeling strategy although they have been unable to articulate why. Others insist that the smile is actually correct and reveals important and relevant tranche-dependent characteristics, but have failed to produce convincing evidence to support this view. In this article the authors present evidence that the correlation smile is really a by-product (artifact) of an unfortunate modeling strategy and has no financial or market-driven interpretation whatsoever. Moreover, the authors argue that this modeling approach should be abandoned at once.TOPICS: CLOs, CDOs, and other structured credit, project finance, credit risk management