BSLP: Markovian Bivariate Spread-Loss Model for Portfolio Credit Derivatives

BSLP is a two-dimensional dynamic model of interacting portfolio-level loss and loss intensity processes. It is constructed as a Markovian, short-rate intensity model, which facilitates fast lattice methods for pricing various portfolio credit derivatives such as tranche options, forward-starting tranches, leveraged super-senior tranches etc. A semiparametric model specification is used to achieve near perfect calibration to any set of consistent portfolio tranche quotes. The one-dimensional local intensity model obtained in the zero volatility limit of the stochastic intensity is useful in its own right for pricing non-standard index tranches by arbitrage-free interpolation. Opinions expressed in this paper are those of the authors, and do not necessarily reflect the view of JP Morgan. We would like to thank Andrew Abrahams, Morten Andersen, Anil Bangia, Rama Cont, Ian Dowker, Kay Giesecke, Dapeng Guan, Regis Guichard, David Liu, Antonio Paras, Philipp Schönbucher, Jakob Sidenius, Nicolas Victoir and Yulia Voevodskaya for valuable discussions. All remaining errors are our own.