CDO Pricing Using Gaussian Mixture Model with Transformation of Loss Distribution

We present a new approach to price CDOˆ2-type transactions consistently with the pricing of the underlying CDOs. We first present an extension to the current market standard model using a Gaussian mixture (GM) copula model instead of one parameter single Gaussian Copula model. It shows that GM broadly captures the correlation skew shown in the index tranche market, but not exactly and across time or across term structure. Then using an analogy to the option pricing for CDO tranche pricing we extract an implied loss distribution from the observed index tranche market or a set of bespoke pricing of the underlying baby portfolios. To strike a balance of matching the underlying baby CDO pricing and having a plausible economic correlation model to price CDOˆ2-type trades we create a loss distribution transformation for each baby CDO portfolio between the implied loss distribution from the index tranche market or bespoke pricing and the loss distribution from the GM model. This way, we can match the ∗The views expressed in this article are not necessarily those of Barclays Bank PLC or any of its affiliates. Please direct any comment to [email protected], phone 212-412-2551 and michaelhong.liang@barcap, phone 212-412-3592.