Credit Derivatives Strategy

London 6 May 2004

A Model for Base Correlation Calculation

• JPMorgan’s implementation of Base Correlations through the Large Pool Model • Open, transparent approach to analysing standardised tranche correlations § Observable calculations § No add-ins required

Credit Derivatives Strategy Lee McGinty*
(44-20) 7325-5482

CDO/Credit Derivatives Strategy Rishad Ahluw alia
(44-20) 7777-1045

The certifying analyst(s) is indicated by an asterisk (*). See last page of the report for analyst certification and important legal and regulatory disclosures.

the market level of tranche spreads are used to calculate the expected loss on the relevant tranche.mcginty@jpmorgan. In this document. The Appendix gives calculation details of our implementation of the Large Pool Model. Lee McGinty and Rishad Ahluwalia. Lee McGinty and Rishad Ahluwalia. or the Large Pool Model). it is a simple methodology that is almost identical to the original Credit Metrics Model (Gupton et Credit Derivatives Strategy London 6 May 2004 Introduction In previous research. we describe the specific implementation of the Large Pool Model that we provide to market participants to illustrate the process. We use it as a standard mechanism for translating market prices to an implied correlation. Firstly. we have described the Base Correlation framework (Credit Correlation: A Guide and Introducing Base Correlations. The variables in the appendix have been given long names to correspond to the relevant range names in the spreadsheet. The model is provided as a description in the appendix and as a spreadsheet. and that the portfolio is homogeneous. 1997). In either case. The Large Pool Model The model that we use for calculating tranche values and spreads from market inputs is called the Homogeneous Large Pool Gaussian Copula Model (HLPGC. 2 . Note that the spreadsheet and model description are provided as an educational and reference tool only. The model then iterates to find the single correlation that when entered as an input for this (0-6 in this example) tranche provides the given expected loss.Lee McGinty (44-20) 7325-5482 lee. April 2004) and At-the-money Correlation (A Relative Value Framework for Credit Correlation. The Large Pool Model works on the assumption that the portfolio can be modeled by a very large number of credits of uniform size. there are some more steps to calculating Base Correlations. or more likely. to use a different model in a Base Correlation Framework. April 2004). These are then combined to form expected losses on the relevant first loss tranche (for instance expected losses on 0-6 tranche are calculated as expected loss on 0-3 plus expected loss on 3-6). It is possible to think of compound correlations with the Large Pool Model. From Large Pool to Base Correlations The use of the Large Pool Model isn’t essential to the use of Base Correlations – they are two separate stages to the process. Many thanks to Siobhan Cooper for her assistance in building and documenting this model. This model is not new.

choose the “Large Pool Model Calculations” workbook tab at the bottom. For instance in our standard definition of the Large Pool Model. From here.mcginty@jpmorgan. the next stage will usually be to enter to market quoted spreads (cells I:20 to J:24). and the interpolated Base Correlations for each point are given (you can overwrite with alternative correlations). There is a consistent colour scheme on the model to help users find their way around. The middle section is where the current market tranches are input – typically the liquid tradable tranches. and then click on the “SolveForCorrs” button to calculate the Base Correlation from these spreads. you will be presented with a disclaimer. if they are existing tranches. The model allows users to type in market prices for tranches and calculates the Base Correlation curve consistent with these prices. The Base Correlation is the single correlation that gives the correct tranche values for the tranches with lower attachment point at zero. All of the calculations are far off to the right and below. It can also be used in reverse to calculate tranche prices from a given input of the Base Correlation Curve. Light blue cells are where users can type in values (or have the model calculate values for them). Almost all of the calculations are provided as worksheet functions – there are macros in the spreadsheet. and is split into three or four main parts. To proceed to the main valuation page. but are provided in as transparent way as possible to ensure the model is open and simple to understand. If these are new tranches. The section below that is for valuing off-market tranches. it is possible to value off-market tranches in the lower section. then the fair (par) spread is given in column N. The darker blue cells are user inputs to define a deal and relevant conventions. The upper and lower attachment points are entered.Lee McGinty (44-20) 7325-5482 lee. but they deal mostly with interpolation and solving etc. 3 . Cells with a yellow background are labels and grey cells have formulae in and should not be changed. and are not needed for dayto-day use. At the top. At-the-money correlation and correlation skew are given in cells L13 and L14. The worksheet “Correlations” contains a chart of the Base Correlation structure. we define discount rates to be zero. Users should only enter values in cells with a blue background. The spreadsheet looks like Figure Credit Derivatives Strategy London 6 May 2004 Using the Model On opening the model.. then enter the deal spreads and the mark to market value will be calculated in column L. Once you have defined the market in terms of constants. and recovery to be 40%. you define market-wide factors or defaults. attachment points etc.

com Credit Derivatives Strategy London 6 May 2004 Figure 1 Screenshot of Large Pool Model in Excel Deal input and conventions On-the-run liquid tranche Off-the-run tranches Source: JPMorgan 4 .mcginty@jpmorgan.Lee McGinty (44-20) 7325-5482 lee.

that is the Large Pool Model. The emphasis is on making the model as transparent as possible. 5 . we need to use a model giving the loss distribution and using as input the average default probability. 1 − recov and the average cumulative default probability of the portfolio PD(horizon ) = 1 − e − cleanSpread ⋅horizon 10000 . and then the Fair Spread and MTM calculations. an average credit spread of spd in basis points and an average recovery of recov. The use of Base Correlations described above requires us to price the tranche as the difference between two first loss pieces: the (0% to tranche upper bound) and (0% to tranche lower bound) tranches. We will first look at the algorithm for determining expected loss. 360 the clean spread of the portfolio cleanSpread = spd . Expected Loss Calculations We consider a portfolio of total notional value Ntnl.Lee McGinty (44-20) 7325-5482 lee. so almost all of the operations performed in the spreadsheet are described in detail.mcginty@jpmorgan. In order to calculate the expected tranche loss. We consider a specific tranching of the portfolio. We also have a value date and maturity date for the portfolio. We calculate the horizon of interest horizon = (MaturityDate − ValueDate) .com Credit Derivatives Strategy London 6 May 2004 Appendix: Large Pool Model Details Introduction In this Appendix we give a detailed background to the calculations performed in the Large Pool Model.

a market spread equal to the mid level of an equivalent quoted DJ TRAC-X unfunded swap and a discount rate of 0. (Please refer to the Credit Metrics Technical documentation. The uniform correlation assumption allows us to reduce the dimensionality of the Credit Metrics problem by introducing a single normal variable m. such that the name Credit Metrics gaussian factor can be decomposed into X n = corr ⋅ m + 1 − corr ⋅ Z n Where Zn is an idiosyncratic factor. We then use the Credit Metrics model with uniform pair-wise correlations corr given by the Base Correlations on these 2 first loss tranches. and m is the common factor. PL= PCum(m) ⋅ (1 − recov) Tranche Loss: We use the large pool assumption here to justify that the portfolio loss will be concentrated at the expected portfolio loss. so that the expected tranche loss is MIN (MAX (PL ⋅ Ntnl . TrancheUpper ⋅ Ntnl ) Ntnl 6 .0 ).Lee McGinty (44-20) 7325-5482 lee. Portfolio Loss: This is the percentage expected loss of the portfolio given m. Where the standardised Large Pool Model uses a recovery rate of Credit Derivatives Strategy London 6 May 2004 Base Correlations are defined as the correlation inputs required for a series of equity tranches that give the tranche values consistent with quoted spreads using the standardised Large Pool Model.). æ Φ −1 (PD(horizon) ) − corr ⋅ m ö ÷ PCum(m) = Φç ç ÷ 1 − corr è ø Where Φ is the standard normal cumulative distribution function. PCum(m): This is the expected percentage default of portfolio P given m.mcginty@jpmorgan. We then calculate the following results conditional on m using the fact that the names defaults are independent conditional on m.

we do the weighted sum of conditional tranche loss. Let UpperLoss be the expected loss of the 0 to tranche upper bound portion of the portfolio priced using the base correlation for that tranche.8.8. we can easily calculate the tranche loss for the tranche of interest. We calculate the expectation conditional on all m ∈ M={-5.Lee McGinty (44-20) 7325-5482 lee.…. To get the unconditional expected tranche loss. Let LowerLoss be the expected loss of the 0 to tranche lower bound portion of the portfolio priced using the base correlation for the 0 to tranche lower tranche.1 ⋅ dΦ ( m ) dm Once we have carried out the above calculations for the first loss tranches. -4. 4. Then tranche loss is TrancheLoss = UpperLoss − LowerLoss and the expected survival of the tranche at horizon is ExpectedSurvival (horizon ) = where (TrancheSize − TrancheLoss ) TrancheSize TrancheSize = (TrancheUpper − TrancheLower ) ⋅ Ntnl 7 . Credit Derivatives Strategy London 6 May 2004 Note that here we do not consider the subordination or the tranche size as all the tranches that we are interested in have a lower attachment point of 0.mcginty@jpmorgan.9 . 4.5} and then use TotalExpectedTrancheLoss = m∈M å w(m) ⋅ TrancheLoss(m ) where the weight w(m) is w(m) = 0.9.

mcginty@jpmorgan. Let T = {t0.Lee McGinty (44-20) 7325-5482 lee. For each t∈T the discount factor for a given input quarterly rate can be calculated æ discountRate ö DF (t ) = ç1 + ÷ 4 è ø −4 t We treat the ExpectedSurvival as a discount factor for the period from value date to horizon.…. tn} be the set of payment dates where t0 is the value date. t1. We assume that the protection buyer pays the protection seller a quarterly fee of a fixed spread on the remaining notional at the payment date. We now have all the ingredients to calculate risk free and risky duration RiskFreeDuration = å DF (t i ) ⋅ DayCount (t i ) i =1 n RiskyDuration = å DF (t i ) ⋅ ExpectedSurvival (t i ) ⋅ DayCount (t i ) i =1 n 8 .com Credit Derivatives Strategy London 6 May 2004 Fair Spread Determination & MTM Calculations We want to use the information that we have from the Large Pool Model to evaluate the price of protection against expected loss in the tranche of interest. define for each t∈T DayCount (t i ) = t i − t i −1 360 For the remainder of this discussion we assume that the discount factors and spreads are quoted on an ACTUAL/360 quarterly basis. We can then convert the ExpectedSurvival to a quarterly survival rate and use the rate to get expected survival factors (or risky discount factors) for each payment date as follows −4 t æ SurvivalRate ö ExpectedSurvival (t ) = ç1 + ÷ 4 è ø where the SurvivalRate is chosen such that this equation holds for t = horizon.

t i −1 ) = ExpectedSurvival (t i −1 ) − ExpectedSurvival (t i ) Given these default probabilities we can evaluate the contingent leg PV (ContingentLeg ) = å PD(t i .com Credit Derivatives Strategy London 6 May 2004 We can now calculate expected incremental tranche loss occuring in the period from ti-1 to ti where ExpectedSurvival(0)= 1.e. the spread at which the PV of the contingent leg is equal to the PV of the fee leg FairSpread = PV (ContingentLeg ) RiskyDuration ⋅ TrancheSize Then the MTM of the protection bought by the client given the actual spread paid is MTM = ( FairSpread − Spread ) ⋅ RiskyDuration ⋅ TrancheSize Note that both FairSpread and Spread have been quoted in Actual/360 quarterly notation. t i −1 ) ⋅ DF (t i ) ⋅ TrancheSize i =1 n We are now also in a position to calculate the “Fair Spread” i. PD(t i .mcginty@jpmorgan.Lee McGinty (44-20) 7325-5482 lee. 9 .

Lee McGinty (44-20) 7325-5482 Credit Derivatives Strategy London 6 May 2004 10 .

Lee McGinty (44-20) 7325-5482 Credit Derivatives Strategy London 6 May 2004 11 .mcginty@jpmorgan.

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