Valuation of collateralized debt obligations with hierarchical Archimedean copulae

• We propose CDO valuation models based on hierarchical Archimedean copulae.
• The models with random loss given defaults improve the results meaningfully.
• We calibrate spreads of the iTraxx Europe tranches.
• We outperform the standard pricing model based on the Gaussian distribution.
• Our models flatten the implied correlation smile.

Modelling portfolio credit risk is one of the crucial challenges faced by financial services industry in the last few years. We propose the valuation model of collateralized debt obligations (CDO) based on hierarchical Archimedean copulae (HAC) with up to three parameters, with default intensities calibrated to market data and with random loss given defaults that are correlated with default times. The methods presented are used to reproduce the spreads of the iTraxx Europe tranches. Our approach describes the market prices better than the standard pricing procedure based on the Gaussian distribution. We also obtain a flat correlation smile across tranches thereby solving the implied correlation puzzle.