The Perfect Copula John Hull and Alan White1 Joseph L.

Rotman School of Management University of Toronto

First Draft: June 2005 This Draft: November 2005

Abstract We present an alternative to the standard Gaussian copula model for valuing CDO tranches. Instead of implying copula correlations from market prices we imply the copula itself. Our model can be exactly fitted to the market quotes for actively traded CDO tranches. It is easy to understand and is a useful tool for pricing, trading, and risk management.

We are grateful to Bill Bobey for research assistance and to Leif Andersen, Jon Gregory, Harald Skarke, and anonymous referees for comments that have improved this paper.

The Perfect Copula John Hull and Alan White The Gaussian copula model has become the standard market model for valuing collateralized debt obligations (CDOs) and similar instruments. Market participants imply base correlations for the standard attachment points of iTraxx and CDX. Market quotes for tranches with non-standard attachment points are obtained by interpolating between these base correlations. In this respect the market uses implied base correlations and the Gaussian copula model in much the same way as it uses implied volatilities and the Black-Scholes model.2 If the Gaussian copula model fitted market prices well the implied base correlation would be approximately the same for all attachment points. In fact the base correlation for the 0 to X% tranche is a fairly steeply increasing function of X (at least beyond X=3). This makes it very difficult to determine the appropriate correlation when the Gaussian copula model is used to value instruments such as CDO squareds.3 It has led a number of researchers have looked for copulas that fit market prices better than the Gaussian copula. Among the copulas that have been considered are the Student-t, double-t, Clayton, Archimedian, and Marshall Ohkin. In this paper we take a different approach. We show how a one-factor copula model can be implied from iTraxx or CDX tranche quotes. The copula that is implied is perfect in that it fits the tranche quotes exactly. What we are doing in this paper is analogous to what Breeden and Litzenberger (1978) and Jackwerth and Rubinstein (1996) did when they implied a future stock price distribution from European option prices. Using a copula that provides a perfect fit to market quotes for all tranches is clearly important when instruments with non-standard structures, such as such as CDO squareds, are valued.

For a description of the CDO market and the implementation of copula models see Hull and White (2004). 3 Again we have an analogy with option pricing. Black-Scholes does not fit option prices well and so it is difficult to know the correct volatility to use when exotic options are valued using Black-Scholes assumptions.

We start by reviewing one-factor copula models and show how an examination of the features of those models led us to develop the implied copula approach.

One-Factor Copula Models Suppose that we are interested in modeling the joint defaults of n different obligors. In a one-factor copula model we first define variables xi (1 i n) by
xi = a i M + 1 ai2 Z i

(1)

where M and the Zis have independent probability distributions with mean zero and standard deviation one. The variable xi can be thought of as a default indicator variable for the ith obligor: the lower the value of the variable, the earlier a default is likely to occur. Each xi has two stochastic components. The first, M, is the same for all xi while the second, Zi, is an idiosyncratic component affecting only xi. Suppose that ti is the time to default of the ith obligor and Qi is the cumulative probability distribution of ti. The copula model maps xi to ti on a percentile to percentile basis. The 5% point on the xi distribution is mapped to the 5% point on the ti distribution; the 10% point on the xi distribution is mapped to the 10% point on the ti distribution; and so on. In general, the point ti = t is mapped to xi = x where

x = Fi 1 Qi ( t )
or equivalently

(2)

t = Qi1 [Fi ( x)] and Fi is the cumulative probability distribution for xi. The copula model defines a correlation structure between the tis while maintaining their marginal distributions. The essence of the copula model is that we do not define the correlation structure between the variables of interest directly. We map the variables of interest into other more manageable variables and define a correlation structure between those variables.

From equation (1)

xa M i Prob ( x < x M ) = H i 1 ai2

where Hi is the cumulative probability distribution of Zi. It follows from equation (2) that
Fi 1 Qi ( t ) ai M Qi ( t M ) = Prob ( ti < t M ) = H i 2 1 ai

(3)

Conditional on M defaults are independent. When using the model to value a CDO tranche we set up a procedure to calculate expected cash flows on the tranche conditional on M and then integrate over M to obtain the unconditional expected cash flows. In the Gaussian copula model both M and the Zi have standard normal distributions. In this case xi also has a standard normal distribution so that Hi = Fi = N for all i where N is the cumulative normal distribution function. As already mentioned the one-factor Gaussian copula model does not fit market data well. This means that the correlation structure between the tis assumed by market participants is different from that defined by equations (1) and (2) when M and the Zi are normal. Equation (3) defines the cumulative probability of default by time t conditional on M. The variable M defines the default environment for the whole life of the model. Once M has been determined the cumulative probability of default Qi is a known function of time. A one-factor copula model can be thought of a model where there are a many possible paths for the Qi and the realization of M defines which will be taken for each i. There is no stochastic evolution for hazard rates or CDS spreads in the model. As M increases Qi(t) decreases for all obligors. There is perfect dependence between the paths in that when the path for one obligor has been specified the paths for all other obligors are determined. In the homogeneous case where the ai and the Qi are the same for all i, the Qpath is the same for all obligors.

Implied Hazard Rate Paths

Instead of formulating the model in terms of conditional Qs we can instead use conditional hazard rates. Define i ( t M ) as the hazard rate at time t conditional on M for company i. The relationship between i ( t M ) and Qi ( t M ) is
t Qi ( t M ) = 1 exp i ( M ) d 0

or equivalently
i ( M ) = dQi ( t M ) dt 1 Qi ( t M )
t =

This equation can be used in conjunction with equation (3) to calculate the hazard rate as a function of time for alternative values of M. We shall refer to this conditional function of time as a hazard rate path. Figure 1 shows results for the Gaussian copula model (M and the Zi both normal) for the situation where the unconditional hazard rate is 1% per year for all obligors and the copula correlation, ai2, is 0.15. It shows that the model has some unrealistic properties. Uncertainty about the future hazard rate decreases with the passage of time (except for a short initial period).. This seems to be a general property of the Gaussian copula model, true for virtually all assumptions about the unconditional hazard rate and the copula correlation. Figure 2 shows results for the double t copula model where M and the Zi have four degrees of freedom. Interestingly, this model is more realistic than the Gaussian copula model in that uncertainty about the hazard rate increases with the passage of time.

The Implied Copula Approach

As we have just seen the one-factor copula model in equation (1) implies a set of paths for the hazard rates of obligors. The probability of each path occurring is determined by the probability distribution for M. We will refer to the set of all possible hazard rate paths and their probabilities as the hazard-rate-path probability distribution. It is easy to see that

the hazard-rate-path probability distribution is the only information we need about the underlying copula in order to value a CDO tranche or similar instrument. Calculating expected cash inflows and expected cash outflows on a CDO tranche for a particular hazard rate path is straightforward. To value a CDO tranche we integrate these expected cash flows over the distribution of hazard rate paths. This suggests a new approach to modeling default correlation. Instead of specifying a copula we specify the hazard-rate-path probability distribution directly. There is a copula corresponding to any particular hazard-rate-path distribution. However, from the perspective of model implementation there is no need to determine what this copula is. At this stage, instead of defining the most general model possible we focus on developing practical implementation procedures. For ease of exposition we start by assuming that a) all obligors have the same hazard rate path4 and b) the hazard rate is constant along each hazard rate path. Later we will explain how these assumptions can be relaxed. We first choose a number of different values for the five-year default rate. The number of values chosen must be sufficiently large to provide enough degrees of freedom to fit the market data and the values chosen must span a plausible range of default rates. Good results are obtained with 20 or more values. It turns out that to fit the market data it is necessary to include some very high default rates and very low default rates in the set. The steps are then as follows: 1. Calculate hazard rate paths corresponding to each value of the five-year default rate. When the hazard rate is constant it equals ln[1Q(5)]/5. 2. Conditional on each hazard rate path, calculate the present value of the cash inflows and the present value of the cash outflows for each CDO tranche and for the credit default swap (CDS) represented by the index. 3. Search for probabilities to assign to the hazard rate paths so that the unconditional expected value of each CDO tranche and the unconditional expected value of the CDS are zero.

The corresponding assumption in the one-factor copula model is that ai and Qi are the same for all i.

Dealing with Stability Issues

The procedure we have outlined so far is open to the criticism that there may be stability issues because many probabilities are being implied from six market quotes. We have not found this to be a serious problem. There are of course liable to be multiple solutions to the problem, but in the tests we have done we have found the solutions to be not greatly different from each other. It appears that the market quotes provide reasonably precise information about the copula being used by the market. To avoid any ambiguity about the results from using the implied copula approach and to create a stable procedure we have standardized our implementation in a number of ways. First we avoid any arbitrariness in the way the five-year default rates are chosen. Suppose we wish to choose n default rates. We choose the spacing between the default rates to reflect the sensitivity of the prices of the six instruments (five CDO tranches and one CDS) to the default rate. The idea here is that when this sensitivity is low we can afford to have the default rates that are considered well spaced whereas when it is high they need to be closer. Suppose that L is the sum of the values of the six instruments when the five-year default rate is zero and U is the sum of the values when it is 100%. We divide the range between L and U into n equal intervals and set the ith five-year default rate to be the one that corresponds to the beginning of the ith interval. Next we avoid the problem of multiple solutions by adding to the objective function a penalty for non-smoothness of the distribution. The problem that is solved is shown in Table A. This is a quadratic programming problem with a unique solution. The parameter c determines the relative importance of smoothness and the fit to market prices. As is usual in financial engineering appropriate values for this parameter are determined by trial and error.5
Recovery Rate Assumption

Research by Altman et al (2002) and Cantor et al (2002) and Hamilton et al (2005) provides empirical support for the existence of a negative correlation between default rates and recovery rates. The best fit relationship reported by Hamilton et al (2005) is
An alternative approach is to minimize the second term in the objective function subject to the first term being less than some small amount.
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RR = 0.52 6.9 DR where RR is the recovery and DR is the annual default rate. Our implied copula procedure can incorporate this relationship. In step 2 above we use a different recovery rate for each hazard rate path.

(4)

When testing the model using data from the second half of 2004 we found that a model with a constant recovery rate of 40% can fit CDX and iTraxx data exactly. However, in tests using more recent data we found it necessary to incorporate the relationship in equation (4) to get an exact fit. The results we will present in the next section use equation (4).
Results

Table B shows iTraxx data and CDX data for August 30, 2005 obtained from Reuters.6 Figure 3 shows the probability density functions obtained for iTraxx and CDX using the 5-year data using 30 points on the distribution. The probability density for iTraxx peaks at a five-year default rate of about 3% while that for CDX peaks at a five-year default rate of about 3.5%. Figure 4 shows the five-year iTraxx distribution when different choices are made for the number of points on the distribution. It shows that the implied probability density is well behaved as the number of points is increased. An implied 10-year default rate distribution can be determined in a similar way to an implied five-year distribution. Figure 5 shows the cumulative probability distribution for the 5-year and 10-year default rate for iTraxx. At this point it is natural to suggest that the methodology be extended to find a 10-year hazard rate path distribution that simultaneously matches the market data for both five and ten year maturities. It is possible to find such a hazard rate path distribution, but it is important to avoid overfitting the model. The model is, loosely speaking, a description of the average hazard rate environment between time zero and some time T as seen at time zero. The model does not say anything about the dynamics of hazard rates. A different type of model is needed to answer a question such as if the hazard rate between now and year 5 is h, what is the probability distribution for hazard rates between years 5 and 10?
We chose August 30, 2005 because a complete set of iTraxx 5- and 10-year bid and offer quotes were available for that day. There was no 10-year data for CDX tranches for that day.
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When valuing CDO tranches and other similar instruments that have maturities between five and ten years, it makes sense to interpolate between default rates. For example, in the case of iTraxx the probabilities that the five- and ten-year default rates will be less than or equal to a threshold level of 10% are 0.985 and 0.900, respectively. From this we can estimate the chance of the seven-year default rate being less than or equal to 10% to be 0.934. Similar calculations can be carried out for other threshold levels and a complete probability distribution for seven-year default rate calculated.
What Determines Correlation?

Researchers used to working with the Gaussian copula model may at this stage be wondering what determines correlations in the implied copula model. The answer is that correlations are determined by the dispersion of hazard rates. If hazard rates were concentrated at a single value the correlation would be zero. A positive correlation arises because when one company has a high hazard rate all companies have high hazard rates; when one company has a low hazard rate all companies have a low hazard rates.
Extensions

One extension of the model is to allow hazard rates to be non-constant. Non-constant hazard rates allow the model to fit a term structure of CDS spreads that is estimated from either CDS or bond data. One approach is to choose the hazard rate paths in step 1 above so that the relative values of 1-year, 2-year, 3-year... CDS contracts, conditional on a hazard rate path, are the same for all hazard rate paths. It is then necessary to match only the CDS spread for one maturity when implying the 5-or 10-year default rate distribution. If this spread is matched so that the value of the corresponding CDS contract is zero, the value of all other CDS contracts must also be zero so that their spreads are also matched. Although the choice of hazard rate paths does have a big effect on the relative values of the CDS spreads, we find that it makes very little difference to the default rate distribution that is implied from data such as that in Table B. Another extension of the model is to allow default rates of the underlying obligors to be different. Suppose that a particular obligor has a CDS spread that is different from the index. For each of the 5- or 10-year default rates (and accompanying hazard rate paths) that are considered for the index we can choose a default rate and accompanying hazard 9

rate path for the obligor such that the ratio of the value of a CDS contract on the index to the value of a CDS contract on the obligor is the same for all hazard rate paths. This ensures that when we match the CDS spread for the index we also do so for the obligor. When the model is extended in this way the CDO calculations become more complicated because not all obligors have the same default probabilities. The approach in Andersen et al (2003) or Hull and White (2004) must be used to calculate loss distributions on the portfolio for each of the index hazard rate paths that are considered. Fortunately the CDO tranches have to be valued only once for each index hazard rate path to determine the aij in Table A. A more complete model would allow the user to choose any set of default rates for an obligor. The default rates for some obligors could have a relatively low standard deviation (so that they are relatively insensitive to the default rate of the index) while those for other obligors could have a relatively high standard deviation (so that they tend to accentuate the default rate of the index). This corresponds to a copula in which the factor loading is different for each name. There is no problem in implementing the more complete model. However calibrating it exactly to market data is quite challenging and as a result the model is much less attractive than the other versions of the model we have discussed.
Valuing Non-Standard Deals

Valuing CDO tranches with non-standard attachment points using the model we have presented is straightforward. Not surprisingly the results are similar to those obtained using base correlations. We have indicated the interpolation approach we recommend for tranches with nonstandard lives. When the underlying portfolio is non-standard it makes sense to divide the companies into a handful of groups. Each group is assigned a default rate equal to P% of the iTraxx or CDX default rate. For example, for a particular portfolio of European companies, the first group might be assigned a default rate of 150% of iTraxx, the second, 125% of iTraxx, and so on. The default rate distribution for each group can be calculated from the default rate distribution of iTraxx and CDX. We have used the model to value more exotic structures such as CDO squareds using Monte Carlo simulation and find that it works well.

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Greek Letters

The natural Greeks for non-standard deals are partial derivatives with respect to the quotes in Table B. These can be readily calculated using the model we propose by perturbing the inputs to the model. The set of 5-or 10-year default rates that are considered do not change. The effect of perturbing the inputs is to change the probabilities assigned to each default rate and the value of nonstandard deals. In the version of the model where different credit default swap spreads are assumed for different obligors it is also possible to calculate partial derivatives with respect to each obligors credit default swap spread.
Conclusions

We have presented a new approach to modeling default correlation. The approach has a number of advantages over the Gaussian copula model and its extensions. First, the model can be exactly fitted to the market quotes for the actively traded CDO tranches of standard portfolios. Second, the model is easier to understand than copula models. Third, the model can easily be used to calculate partial derivatives with respect to market quotes such as those in Table B. Fourth, the model can be used to value non-standard CDOs and more exotic structures such as CDO squareds. Finally, the model is ideally suited for trading. A trader can first calculate the implied distributions such as those in Figures 3. She can then investigate the effect on market prices of modifying the distributions to reflect her beliefs. There are limitations of the model. Like the Gaussian copula it does not involve the dynamic evolution of hazard rates or credit spreads. It is therefore inappropriate for some instruments. For example, the model is not appropriate for valuing a one-year option on a five-year CDO because this depends on hazard rates between years one and five conditional on what we observe happening during the first year.

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References

Altman, E.I., B. Brady, A. Resti, and A. Sironi, The link between default rates and recovery rates: implications for credit risk models and procyclicality, Working Paper, Stern School of Business, New York University, April 2002. Andersen, L., J. Sidenius, and S. Basu, All Your Hedges in One Basket, RISK, November, 2003. Breeden D. T. and R. H. Litzenberger, Prices of state-contingent claims implicit in option prices, Journal of Business, 51 (1978), 621-51. Cantor, R., D.T. Hamilton, and S. Ou, Default rates and recovery rates of corporate bond issuers, Moodys Investors Services, February, 2002. Hamilton, D.T., P. Varma, S. Ou, and R. Cantor, Default and recovery rates of corporate bond issuers, Moodys Investors Services, January 2004. Hull, J. and A. White, Valuation of a CDO and nth to Default CDS Without Monte Carlo Simulation, Journal of Derivatives, 12, 2 (Winter 2004), 8-23. Jackwerth, J. C. and M. Rubinstein, Recovering probability distributions from option prices, Journal of Finance, 51 (December 1996), 1611-31.

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Table A The Optimization

Suppose we have determined n five-year default rates and these, when arranged in increasing order, are d1, d2, dn . We have quotes for six instruments (five CDO tranches and one CDS index). Define aij as the value of the jth instrument for the ith default rate and pi as the probability assigned to the ith default rate. The value of the jth instrument is

V j = pi aij
i =1

If Vj=0 for all j the model is consistent with the market. We choose the pi to minimize 6 n 1 ( pi+1 + pi1 2 pi )2 2 V j + c 0.5(d d ) 1 i =2 i +1 i 1

subject to

p
i =1

=1

and
pi 0

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Table B Quotes for CDX IG and iTraxx IG Tranches on August 30, 2005. Source: Reuters
CDX IG Tranches
5-year Quotes 0% to 3% 40 3% to 7% 127 7% to 10% 35.5 10% to 15% 20.5 15% to 30% 9.5 Index 50

iTraxx IG Tranches
5-year Quotes 10-year Quotes 0% to 3% 24 53 3% to 6% 81 395 6% to 9% 26.5 90 9% to 12% 15 52 12% to 22% 9 29 Index 36.375 57.625

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Figure 1

Hazard Rate Paths for the Gaussian copula model when the unconditional hazard rate is 1% per year and the correlation is 15%
0.06 0.05 0.04 0.03 0.02 0.01 0.00 0 1 2 3 4 5 6

M = -2 M = -1 M=0 M=1 M=2

15

Figure 2

Hazard Rate Paths for the double t copula model when the unconditional hazard rate is 1% per year and the correlation is 15%

0.03 0.03 0.02 0.02 0.01 0.01 0.00 0 1 2 3 4 5 6 M = -2 M = -1 M=0 M=1 M=2

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Figure 3 Implied Probability Densities for the 5-Year Default Rate for iTraxx and CDX on August 30, 2005
30

25 5Y iTraxx 20 5Y CDX 15

10

0 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

17

Figure 4 Effect of increasing number of points when estimating the 5-year iTraxx default rate distribution on August 30, 2005
25

20
20 30

15

50 100

10

0 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

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Figure 5 Implied Cumulative Distribution for 5-year and 10-year default rate on August 30, 2005
1

0.75 5Y iTraxx 10Y iTraxx

0.5

0.25

0 0 0.05 0.1 0.15 0.2 0.25 0.3

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