# Copula Function Approach

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Li (2000) introduced copula function approach in the aspect of evaluating credit derivatives, the copula function has gradually become the main approach in pricing CDO (Burtschell & George, 2005). In Li (2000) paper, a new random variable named ‘time-until-default’ was created to demonstrate survival time of each defaultable entity. And the copula function approach is based on this random variable to evaluate the default probability of financial instruments. Specifically, copula function specify the joint distribution of the survival times after using the market information to derive the marginal distribution of the survival time. This approach solves the default correlation and the joint distribution of the pool asset to some extent, and it …show more content…
It is because that, with the natural of ‘heavy tail’ in financial asset return, t copula uses the t distribution which is more suitable than the Gaussian copula model. When using the Gaussian copula model for evaluating asset value, default correlation will be underestimated, and this will generate undervalue junior-tranches and overvalue senior-tranches. The t copula with the fat tail feature could produce the more accurate joint default probability and more accurate valuation. And at the end of the paper, it points the drawbacks of the t copula model, which is static evaluation process and the credit spread dynamic cannot be solved in the t copula model. The paper also states that the conditional copula model maybe more appropriate than the t copula …show more content…
And this model is not much relying on the history data as the BET model. The copula approach is directly specifies the dependence structure, through in a specific method (Burtschell & George 2005). The core thought of the copula model is that using the copula function to calculate the joint distribution by known each asset’s default marginal distribution, and then use the Monte Carlo method to evaluate the distribution of aggregate losses. After that, it is straightforward to calculate each tranche’s price under the assumption which is expected value of default leg and expected value of premium leg are equal. The copula model’s formula is introduced as

• ## Multiple Choice Questions And Analysis: Fundamental Concepts Of Derivatives

There is the type of derivatives some are traded while other underlying assets are non-traded. The best example is the derivate on weathers and index that are non-traded. Question 4 Application of Arbitrage Arbitrage: Arbitrage is a technique used by financial experts whereby the purchase and sell at the same time by exploiting the difference in price. It is the risk-free profit. There don’t have to be any investment.…

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• ## The Security Market And The Capital Market Line

In CAPM the relation between the security risk and return is linear. If the risk is higher the expected return will be high (Blanchard, 2014). If we talk about against the Capital Asset pricing model of its drawbacks. Its assumptions will first come in mind because they are unrealistic. Like totally risk free security which is difficult to find.…

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• ## The Discounted Cash Flow Method

b) Discount rate: Basically VC required the higher target rate of return of 30% - 70% to discount the future cash flow. It is vary on nature of business and the probability of failure. The higher rate reduced the value of the new firm. Unlikely, DCF used lower discount rate such as cost of equity, cost of debt and WACC for discounting the future cash flows. That gives the higher value to firm and higher return to share holder.…

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• ## FX Derivatives Case Study

The exchange requires the hedger who holds the position in a future contract to maintain a margin account, which entails an additional cost. However, the main disadvantage of futures is the difficulty of matching the exact amount and the maturity date to hedge the underlying currency exposure, which allows future contracts to be tradable and be closed prior to the maturity date. There are a number of factors that can cause forward and futures prices to be different; although in the FX market the difference is statistically and economically insignificant (Cornell and Reinganum, 1981). Despite different features, both forward and futures contracts serve the same…

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• ## The Concept Of Expound On Credit Analysis

In case of convexity, duration is adjusted by selecting a time period in order to determine how bond price changes as the interest change in the market. From this, it can be determined that duration plays a key role in performing the process of convexity on bonds or stocks (Johnson, 2010). 3. a) Define classical immunization. How do we use it in bond portfolio management (BPM)? Classical immunization can be defined as the process that helps to create a bond portfolio by assuming the rate of return for a specific time period.…

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• ## Comparing Two Approaches To Financial Reporting

Historical cost accounting is objective and also easy to use (Daines, 1929). Moreover, historical cost accounting provides relevant information for managers to forecast future costs, which is based on historical costs is the basis (Ijiri,1975). However, Solomons (1961) argues that values at historical cost will be irrelevant when in a high inflation. Moreover, Penman (2007) says that when investors use information provided at historical cost accounting to consider the current and future financial positions, information is irrelevant because historical price cannot reflects timely information. Historical cost accounting can cause misleading as well.…

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• ## Tax Preference Theory: Tax Preference Theory And Bird In Hand Theory

Auerbach and Hassett (2003) states that the dividends are taxed immediately if the dividend tax rate always higher that capital gain rate. It will result what the tax preference explanation suggest that a low level of dividend payout is preferable as to maximize the value and wealth of shareholder. A company will be more likely to use stock repurchases or otherwise retain earnings as a way to return corporate earnings to the shareholder. Favorable treatment for capital gains over dividends would lead to an over-investment of firms financing new investment through retained earnings. This may be more heavily concentrated in certain sectors of the economy, thereby distorting the allocation of resources.…

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• ## Theories Of Markowitz Portfolio Theory

Markowitz Portfolio Theory One of the major area of finance is optimizing the portfolio. Basically, portfolio theory deals with the risk and value of portfolio instead of individual securities, which is known as Markowitz portfolio theory that is suggested by Harry Markowitz in his article “Portfolio selection” in the Journal of Finance. Markowitz portfolio theory basically helps in making optimum portfolio by interpreting, and evaluating risk and return of different risky assets. Basically, the portfolio theory is all about analyzing the balance in between the minimizing risk and maximizing return. However, the objective of this theory is to select one’s investment in that which could diversify the risk without reducing the expected return.…

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• ## Pricing Bonds In The Australian Market Analysis

It also reflects the market participants’ assessment of various monetary policy conditions (Rogers 1995). Theoretically, an efficient market implies that various irregularities in the yield curve can be efficiently priced out by arbitrageurs thereby leading to significant predictability within the term structure (Christopher M. Bilson 2008). However, the nature of financial markets makes it quite difficult to identify an observable continuous term structure in reality. One of the basic uses of the term structure entails the valuation of a coupon bond (Christopher M. Bilson 2008). In this case, a coupon bond is reduced into individual cash flows valued as zero coupon bonds.…

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• ## The Strengths Of The Arbitrage Pricing Model

The TFM shows that a positive alpha in a CAPM regression is generally due to exposure to either SMB or HML factors, instead of actual manager performance. Whereas, with the TFM a reliable measure of alpha can be observed. A positive measure of alpha with the TFM would suggest that the mutual fund manager is adding value to the portfolio, beyond simply dividing invesments to produce varying degrees of exposure to the three risk factors. Finally, the Fama French model explains more of the variation in asset returns, exhibiting R2 values of 0.95 and higher. (Womack and Zhang,…

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