Model For Base Correlations
Model For Base Correlations
London
6 May 2004
The certifying analyst(s) is indicated by an asterisk (*). See last page of the http://mm.jpmorgan.com
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
Introduction
In previous research, we have described the Base Correlation framework (Credit
Correlation: A Guide and Introducing Base Correlations, Lee McGinty and Rishad
Ahluwalia, April 2004) and At-the-money Correlation (A Relative Value Framework
for Credit Correlation, Lee McGinty and Rishad Ahluwalia, April 2004). In this
document, we describe the specific implementation of the Large Pool Model that we
provide to market participants to illustrate the process.
Many thanks to Siobhan Cooper for her assistance in building and documenting this
model.
The Large Pool Model works on the assumption that the portfolio can be modeled by
a very large number of credits of uniform size, and that the portfolio is homogeneous.
The Appendix gives calculation details of our implementation of the Large Pool
Model.
Firstly, the market level of tranche spreads are used to calculate the expected loss on
the relevant tranche. These are then combined to form expected losses on the relevant
first loss tranche (for instance expected losses on 0-6 tranche are calculated as
expected loss on 0-3 plus expected loss on 3-6). The model then iterates to find the
single correlation that when entered as an input for this (0-6 in this example) tranche
provides the given expected loss.
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
The model allows users to type in market prices for tranches and calculates the Base
Correlation curve consistent with these prices. It can also be used in reverse to
calculate tranche prices from a given input of the Base Correlation Curve.
The spreadsheet looks like Figure 1, and is split into three or four main parts. At the
top, you define market-wide factors or defaults. The middle section is where the
current market tranches are input – typically the liquid tradable tranches. The section
below that is for valuing off-market tranches.
All of the calculations are far off to the right and below, and are not needed for day-
to-day use, but are provided in as transparent way as possible to ensure the model is
open and simple to understand. Almost all of the calculations are provided as
worksheet functions – there are macros in the spreadsheet, but they deal mostly with
interpolation and solving etc.
There is a consistent colour scheme on the model to help users find their way around.
Cells with a yellow background are labels and grey cells have formulae in and should
not be changed. Users should only enter values in cells with a blue background. The
darker blue cells are user inputs to define a deal and relevant conventions. For
instance in our standard definition of the Large Pool Model, we define discount rates
to be zero, and recovery to be 40%.
Light blue cells are where users can type in values (or have the model calculate
values for them).
Once you have defined the market in terms of constants, attachment points etc., the
next stage will usually be to enter to market quoted spreads (cells I:20 to J:24), and
then click on the “SolveForCorrs” button to calculate the Base Correlation from these
spreads. The Base Correlation is the single correlation that gives the correct tranche
values for the tranches with lower attachment point at zero. At-the-money correlation
and correlation skew are given in cells L13 and L14.
From here, it is possible to value off-market tranches in the lower section. The upper
and lower attachment points are entered, and the interpolated Base Correlations for
each point are given (you can overwrite with alternative correlations). If these are
new tranches, then the fair (par) spread is given in column N, if they are existing
tranches, then enter the deal spreads and the mark to market value will be calculated
in column L.
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
Off-the-run tranches
Source: JPMorgan
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
horizon =
(MaturityDate − ValueDate) ,
360
spd
cleanSpread = ,
1 − recov
cleanSpread
− ⋅horizon
PD(horizon ) = 1 − e 10000
.
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
Base Correlations are defined as the correlation inputs required for a series of equity
tranches that give the tranche values consistent with quoted spreads using the
standardised Large Pool Model. Where the standardised Large Pool Model uses a
recovery rate of 40%, a market spread equal to the mid level of an equivalent quoted
DJ TRAC-X unfunded swap and a discount rate of 0. We then use the Credit Metrics
model with uniform pair-wise correlations corr given by the Base Correlations on
these 2 first loss tranches. (Please refer to the Credit Metrics Technical
documentation.).
X n = corr ⋅ m + 1 − corr ⋅ Z n
æ Φ −1 (PD(horizon) ) − corr ⋅ m ö
PCum(m) = Φçç ÷
÷
è 1 − corr ø
Portfolio Loss: This is the percentage expected loss of the portfolio given m.
Tranche Loss: We use the large pool assumption here to justify that the portfolio
loss will be concentrated at the expected portfolio loss, so that the expected tranche
loss is
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
Note that here we do not consider the subordination or the tranche size as all the
tranches that we are interested in have a lower attachment point of 0.
We calculate the expectation conditional on all m ∈ M={-5, -4.9, -4.8,…, 4.8, 4.9 ,5}
and then use
dΦ ( m )
w(m) = 0.1 ⋅
dm
Once we have carried out the above calculations for the first loss tranches, we can
easily calculate the tranche loss for the tranche of interest. Let LowerLoss be the
expected loss of the 0 to tranche lower bound portion of the portfolio priced using the
base correlation for the 0 to tranche lower tranche. Let UpperLoss be the expected
loss of the 0 to tranche upper bound portion of the portfolio priced using the base
correlation for that tranche. Then tranche loss is
ExpectedSurvival (horizon ) =
(TrancheSize − TrancheLoss )
TrancheSize
where
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
Let T = {t0, t1,…, tn} be the set of payment dates where t0 is the value date, define for
each t∈T
t i − t i −1
DayCount (t i ) =
360
For the remainder of this discussion we assume that the discount factors and spreads
are quoted on an ACTUAL/360 quarterly basis. For each t∈T the discount factor for
a given input quarterly rate can be calculated
−4 t
æ discountRate ö
DF (t ) = ç1 + ÷
è 4 ø
We treat the ExpectedSurvival as a discount factor for the period from value date to
horizon. We can then convert the ExpectedSurvival to a quarterly survival rate and
use the rate to get expected survival factors (or risky discount factors) for each
payment date as follows
−4 t
æ SurvivalRate ö
ExpectedSurvival (t ) = ç1 + ÷
è 4 ø
where the SurvivalRate is chosen such that this equation holds for t = horizon.
We now have all the ingredients to calculate risk free and risky duration
n
RiskFreeDuration = å DF (t i ) ⋅ DayCount (t i )
i =1
n
RiskyDuration = å DF (t i ) ⋅ ExpectedSurvival (t i ) ⋅ DayCount (t i )
i =1
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
We can now calculate expected incremental tranche loss occuring in the period from
ti-1 to ti
where ExpectedSurvival(0)= 1.
n
PV (ContingentLeg ) = å PD(t i , t i −1 ) ⋅ DF (t i ) ⋅ TrancheSize
i =1
We are now also in a position to calculate the “Fair Spread” i.e. the spread at which
the PV of the contingent leg is equal to the PV of the fee leg
PV (ContingentLeg )
FairSpread =
RiskyDuration ⋅ TrancheSize
Then the MTM of the protection bought by the client given the actual spread paid is
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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
10
Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
11
Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004
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