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On Models of Stochastic Recovery for Base Correlation

Li, Hui (2009): On Models of Stochastic Recovery for Base Correlation.

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This paper discusses various ways to add correlated stochastic recovery to the base correlation framework for pricing CDOs. Several recent models are extended to more general framework. The pros and cons of these models for calibration to single name CDS and index CDO tranches are discussed. It is shown that negative forward recovery rate under fixed systematic factor appears in these models. This suggests that current static copula models of correlated default and recovery processes are inherently inconsistent.

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