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Pricing structured products with economic covariates
Affiliation:1. Federal Home Loan Bank of Des Moines, 909 Locust St, Des Moines, IA 50309, United States;2. C.T. Bauer College of Business, University of Houston, 4750 Calhoun Rd, Houston, TX 77004, United States;1. Vanderbilt University. VU Station B, Box 351819, Nashville, TN 37235, USA;2. KAIST College of Business. 85 Hoegiro, Dongdaemun-Gu, Seoul 02455, Republic of Korea;1. John Chambers College of Business and Economics, West Virginia University, P.O. Box 6025, Morgantown, WV 26506, United States;2. College of Business, Florida International University, Modesto A. Maidique Campus, 11200 S.W. 8th St, RB 208B Miami, FL 33199, United States;3. Miami Herbert Business School, University of Miami, 514E Jenkins Building, 5250 University Drive Coral Gables, FL 33124, United States;1. Jesse H. Jones School of Business at Rice University, 321 McNair Hall, MS 531, 6100 Main Street, Houston, TX 77005, USA;2. US Securities and Exchange Commission, 100 F St NE, Washington, DC 20549, USA;3. Michael G. Foster School of Business at the University of Washington, 428 PACCAR Hall, Box 353226, Seattle, WA 98195, USA;1. University of Toronto, Canada;2. University of Southern California, Marshall School of Business, Los Angeles, CA 90089, United States;3. Harvard Business School, Boston, MA 02163, United States;1. INSEAD, Boulevard de Constance, 77300 Fontainebleau, France;2. Federal Reserve of St. Louis, Federal Reserve Bank Plaza, 1 Broadway, St. Louis, MO 63102, United States;1. CEPR, United Kingdom;2. Institute for Financial Management, University of Bern, Office 214, Engehaldenstrasse 4, Bern CH - 3012, Switzerland
Abstract:We introduce a top-down no-arbitrage model for pricing structured products. Losses are described by Cox processes whose intensities depend on economic variables. The model provides economic insight into the impact of structured products on financial institutions’ risk exposure and systemic risk. We estimate the model using CDO data and find that spreads decrease with higher interest rates and increase with volatility and leverage. Volatility is the primary determinant of variation in tranche spreads. Leverage and interest rates are more closely associated with rare credit events. Model-implied risk premiums and the probabilities of tranche losses increase substantially during the financial crisis.
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