Working Paper: NBER ID: w15734
Authors: Pierre Collin-Dufresne; Robert S. Goldstein; Fan Yang
Abstract: We investigate a structural model of market and firm-level dynamics in order to jointly price long-dated S&P 500 options and tranche spreads on the five-year CDX index. We demonstrate the importance of calibrating the model to match the entire term structure of CDX index spreads because it contains pertinent information regarding the timing of expected defaults and the specification of idiosyncratic dynamics. Our model matches the time series of tranche spreads well, both before and during the financial crisis, thus offering a resolution to the puzzle reported by Coval, Jurek and Stafford (2009).
Keywords: SP 500 options; CDX tranches; credit derivatives; structural model
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Calibrating the model to match the entire term structure of CDX index spreads (C50) | Accurately pricing long-dated SP 500 options (G13) |
| Calibrating the model to match the entire term structure of CDX index spreads (C59) | Resolving discrepancies in pricing during the financial crisis (G19) |
| The model's calibration to the term structure (C50) | Pricing of tranches (G19) |
| Without proper calibration (C29) | The model underpredicts default rates for investment-grade debt (G33) |
| Calibration impacts the proportion of risk attributed to idiosyncratic versus systematic factors (D80) | Tranche pricing (G19) |
| The model outperforms previous models in matching historical tranche prices (G19) | Accuracy of pricing in the market (D41) |