Modeling credit portfolio derivatives, including both a default and a prepayment feature

Apart from heteronomy exit events like, e.g., credit default or death, several financial agreements allow policy holders to voluntarily terminate the contract. Examples include callable mortgages or life insurance contracts. For the contractual counterpart, the result is a cash-flow uncertainty called prepayment risk. Despite the high relevance of this implicit option, only few portfolio models consider both a default and a cancellability feature. On a portfolio level this is especially critical, since empirical observations of the mortgage market suggest that prepayment risk is an important determinant for the pricing of mortgage-backed securitites (MBS) (see, e.g., Deng et al. [2000], Chow et al. [2000], Maxam and Lacour-Little [2001]). Furthermore, defaults and prepayments tend to occur in clusters (see, e.g., Dobránszky and Schoutens [2009]) and there is evidence for a negative association between the two risks. This paper presents a realistic and tractable portfolio model that takes into account these observations. Technically, we rely on an Archimedean dependence structure. A suitable parameterization allows to fit the likelihood of default and prepayment clusters separately and accounts for the postulated negative interdependence. Moreover, this structure turns out to be tractable enough for real-time evaluation of portfolio derivatives. As an application, the pricing of loan-credit-default-swaps (LCDS), an example of a portfolio derivative that includes a cancellability feature, is discussed.      «

Apart from heteronomy exit events like, e.g., credit default or death, several financial agreements allow policy holders to voluntarily terminate the contract. Examples include callable mortgages or life insurance contracts. For the contractual counterpart, the result is a cash-flow uncertainty called prepayment risk. Despite the high relevance of this implicit option, only few portfolio models consider both a default and a cancellability feature. On a portfolio level this is especially critical...     »