Efficient hybrid methods for portfolio credit derivatives

Abstract

In this paper we discuss the computation of basket credit default swaps and collateralized debt obligation squared transactions. We suggest two hybrid algorithms for these two portfolio credit derivatives. The method combines the analytic approximation to the loss distribution of conditionally independent heterogeneous portfolios with the Monte Carlo simulation. The efficiency and accuracy of the algorithms are illustrated with examples.

Keywords:

• Heterogeneous portfolios
• Normal approximations
• Hybrid algorithms
• Basket credit default swaps
• CDO squared distributions

Acknowledgements

The author thanks Y.K. Shen for useful discussions and help with implementing the examples. The author also thanks the referees for helpful suggestions for earlier versions.