Loss Distribution Evaluation for Synthetic CDOs

Efficient numerical methods for evaluating the loss distributions of synthetic CDOs are important for both pricing and risk management purposes. In this paper we discuss several methods for loss distribution evaluations. We first develop a stable recursive method. Then the improved compound Poisson approximations proposed by Hipp [12] are introduced. Finally, the normal power approximation method that has been used in actuarial science is described. The recursive method computes the loss distribution exactly, whereas the other two methods compute the loss distribution approximately. Numerical results based on these three and some known methods for synthetic CDO pricing are given. This research was supported in part by the Natural Sciences and Engineering Research Council (NSERC) of Canada. Department of Computer Science, University of Toronto, 10 King’s College Rd, Toronto, ON, M5S 3G4, Canada; [email protected] Algorithmics Inc., 185 Spadina Avenue, Toronto, ON, M5T 2C6, Canada; [email protected] Department of Computer Science, University of Toronto, 10 King’s College Rd, Toronto, ON, M5S 3G4, Canada; [email protected]