Dynamic modeling of the correlation smile

Abstract

We discuss the equity-based pricing of CDX tranches within a structural dynamic approach and focus on the valuation impact of general model specifications. Therefore, we examine the influence of market dynamics, idiosyncratic jumps, loss term structures, and portfolio heterogeneity on the pricing of tranches. The resulting spread deviations are quantified through implied correlations because this scales premium payments across all tranches to a comparable level and, in addition, enables reliable inferences on the meaning of the discussed model features.