Credit Derivatives Strategy

London
6 May 2004

A Model for Base Correlation

Calculation

• JPMorgan’s implementation of Base Correlations through the

Credit Derivatives Strategy
Large Pool Model
Lee McGinty*
• Open, transparent approach to analysing standardised tranche (44-20) 7325-5482
lee.mcginty@jpmorgan.com
correlations
CDO/Credit Derivatives Strategy
§ Observable calculations
§ No add-ins required Rishad Ahluw alia
(44-20) 7777-1045
rishad.ahluwalia@jpmorgan.com

The certifying analyst(s) is indicated by an asterisk (*). See last page of the http://mm.jpmorgan.com
report for analyst certification and important legal and regulatory disclosures.
Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Introduction
In previous research, we have described the Base Correlation framework (Credit
Correlation: A Guide and Introducing Base Correlations, Lee McGinty and Rishad
Ahluwalia, April 2004) and At-the-money Correlation (A Relative Value Framework
for Credit Correlation, Lee McGinty and Rishad Ahluwalia, April 2004). In this
document, we describe the specific implementation of the Large Pool Model that we
provide to market participants to illustrate the process.

The model is provided as a description in the appendix and as a spreadsheet. The

variables in the appendix have been given long names to correspond to the relevant
range names in the spreadsheet. Note that the spreadsheet and model description are
provided as an educational and reference tool only.

Many thanks to Siobhan Cooper for her assistance in building and documenting this
model.

The Large Pool Model

The model that we use for calculating tranche values and spreads from market inputs
is called the Homogeneous Large Pool Gaussian Copula Model (HLPGC, or the
Large Pool Model). This model is not new; it is a simple methodology that is almost
identical to the original Credit Metrics Model (Gupton et al, 1997). We use it as a
standard mechanism for translating market prices to an implied correlation.

The Large Pool Model works on the assumption that the portfolio can be modeled by
a very large number of credits of uniform size, and that the portfolio is homogeneous.

The Appendix gives calculation details of our implementation of the Large Pool
Model.

From Large Pool to Base Correlations

The use of the Large Pool Model isn’t essential to the use of Base Correlations – they
are two separate stages to the process. It is possible to think of compound
correlations with the Large Pool Model, or more likely, to use a different model in a
Base Correlation Framework. In either case, there are some more steps to calculating
Base Correlations.

Firstly, the market level of tranche spreads are used to calculate the expected loss on
the relevant tranche. These are then combined to form expected losses on the relevant
first loss tranche (for instance expected losses on 0-6 tranche are calculated as
expected loss on 0-3 plus expected loss on 3-6). The model then iterates to find the
single correlation that when entered as an input for this (0-6 in this example) tranche
provides the given expected loss.

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Using the Model

On opening the model, you will be presented with a disclaimer. To proceed to the
main valuation page, choose the “Large Pool Model Calculations” workbook tab at
the bottom.

The model allows users to type in market prices for tranches and calculates the Base
Correlation curve consistent with these prices. It can also be used in reverse to
calculate tranche prices from a given input of the Base Correlation Curve.

The spreadsheet looks like Figure 1, and is split into three or four main parts. At the
top, you define market-wide factors or defaults. The middle section is where the
current market tranches are input – typically the liquid tradable tranches. The section
below that is for valuing off-market tranches.

All of the calculations are far off to the right and below, and are not needed for day-
to-day use, but are provided in as transparent way as possible to ensure the model is
open and simple to understand. Almost all of the calculations are provided as
worksheet functions – there are macros in the spreadsheet, but they deal mostly with
interpolation and solving etc.

There is a consistent colour scheme on the model to help users find their way around.
Cells with a yellow background are labels and grey cells have formulae in and should
not be changed. Users should only enter values in cells with a blue background. The
darker blue cells are user inputs to define a deal and relevant conventions. For
instance in our standard definition of the Large Pool Model, we define discount rates
to be zero, and recovery to be 40%.

Light blue cells are where users can type in values (or have the model calculate
values for them).

Once you have defined the market in terms of constants, attachment points etc., the
next stage will usually be to enter to market quoted spreads (cells I:20 to J:24), and
then click on the “SolveForCorrs” button to calculate the Base Correlation from these
spreads. The Base Correlation is the single correlation that gives the correct tranche
values for the tranches with lower attachment point at zero. At-the-money correlation
and correlation skew are given in cells L13 and L14.

From here, it is possible to value off-market tranches in the lower section. The upper
and lower attachment points are entered, and the interpolated Base Correlations for
each point are given (you can overwrite with alternative correlations). If these are
new tranches, then the fair (par) spread is given in column N, if they are existing
tranches, then enter the deal spreads and the mark to market value will be calculated
in column L.

The worksheet “Correlations” contains a chart of the Base Correlation structure.

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Figure 1 Screenshot of Large Pool Model in Excel

Deal input and conventions

On-the-run liquid tranche

Off-the-run tranches

Source: JPMorgan

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Appendix: Large Pool Model Details

Introduction
In this Appendix we give a detailed background to the calculations performed in the
Large Pool Model. The emphasis is on making the model as transparent as possible,
so almost all of the operations performed in the spreadsheet are described in detail.
We will first look at the algorithm for determining expected loss, that is the Large
Pool Model, and then the Fair Spread and MTM calculations.

Expected Loss Calculations

We consider a portfolio of total notional value Ntnl, an average credit spread of spd
in basis points and an average recovery of recov. We also have a value date and
maturity date for the portfolio. We calculate the horizon of interest

horizon =
(MaturityDate − ValueDate) ,
360

the clean spread of the portfolio

spd
cleanSpread = ,
1 − recov

and the average cumulative default probability of the portfolio

cleanSpread
− ⋅horizon
PD(horizon ) = 1 − e 10000
.

We consider a specific tranching of the portfolio. In order to calculate the expected

tranche loss, we need to use a model giving the loss distribution and using as input
the average default probability. The use of Base Correlations described above
requires us to price the tranche as the difference between two first loss pieces: the
(0% to tranche upper bound) and (0% to tranche lower bound) tranches.

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Base Correlations are defined as the correlation inputs required for a series of equity
tranches that give the tranche values consistent with quoted spreads using the
standardised Large Pool Model. Where the standardised Large Pool Model uses a
recovery rate of 40%, a market spread equal to the mid level of an equivalent quoted
DJ TRAC-X unfunded swap and a discount rate of 0. We then use the Credit Metrics
model with uniform pair-wise correlations corr given by the Base Correlations on
these 2 first loss tranches. (Please refer to the Credit Metrics Technical
documentation.).

The uniform correlation assumption allows us to reduce the dimensionality of the

Credit Metrics problem by introducing a single normal variable m, such that the
name Credit Metrics gaussian factor can be decomposed into

X n = corr ⋅ m + 1 − corr ⋅ Z n

Where Zn is an idiosyncratic factor, and m is the common factor. We then calculate

the following results conditional on m using the fact that the names defaults are
independent conditional on m.

PCum(m): This is the expected percentage default of portfolio P given m.

æ Φ −1 (PD(horizon) ) − corr ⋅ m ö
PCum(m) = Φçç ÷
÷
è 1 − corr ø

Where Φ is the standard normal cumulative distribution function.

Portfolio Loss: This is the percentage expected loss of the portfolio given m.

PL= PCum(m) ⋅ (1 − recov)

Tranche Loss: We use the large pool assumption here to justify that the portfolio
loss will be concentrated at the expected portfolio loss, so that the expected tranche
loss is

MIN (MAX (PL ⋅ Ntnl ,0 ), TrancheUpper ⋅ Ntnl )

Ntnl

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(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Note that here we do not consider the subordination or the tranche size as all the
tranches that we are interested in have a lower attachment point of 0.

To get the unconditional expected tranche loss, we do the weighted sum of

conditional tranche loss.

We calculate the expectation conditional on all m ∈ M={-5, -4.9, -4.8,…, 4.8, 4.9 ,5}
and then use

TotalExpectedTrancheLoss = å w(m) ⋅ TrancheLoss(m )

m∈M

where the weight w(m) is

dΦ ( m )
w(m) = 0.1 ⋅
dm
Once we have carried out the above calculations for the first loss tranches, we can
easily calculate the tranche loss for the tranche of interest. Let LowerLoss be the
expected loss of the 0 to tranche lower bound portion of the portfolio priced using the
base correlation for the 0 to tranche lower tranche. Let UpperLoss be the expected
loss of the 0 to tranche upper bound portion of the portfolio priced using the base
correlation for that tranche. Then tranche loss is

TrancheLoss = UpperLoss − LowerLoss

and the expected survival of the tranche at horizon is

ExpectedSurvival (horizon ) =
(TrancheSize − TrancheLoss )
TrancheSize
where

TrancheSize = (TrancheUpper − TrancheLower ) ⋅ Ntnl

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

Fair Spread Determination & MTM Calculations

We want to use the information that we have from the Large Pool Model to evaluate
the price of protection against expected loss in the tranche of interest. We assume
that the protection buyer pays the protection seller a quarterly fee of a fixed spread
on the remaining notional at the payment date.

Let T = {t0, t1,…, tn} be the set of payment dates where t0 is the value date, define for
each t∈T

t i − t i −1
DayCount (t i ) =
360

For the remainder of this discussion we assume that the discount factors and spreads
are quoted on an ACTUAL/360 quarterly basis. For each t∈T the discount factor for
a given input quarterly rate can be calculated

−4 t
æ discountRate ö
DF (t ) = ç1 + ÷
è 4 ø

We treat the ExpectedSurvival as a discount factor for the period from value date to
horizon. We can then convert the ExpectedSurvival to a quarterly survival rate and
use the rate to get expected survival factors (or risky discount factors) for each
payment date as follows

−4 t
æ SurvivalRate ö
ExpectedSurvival (t ) = ç1 + ÷
è 4 ø

where the SurvivalRate is chosen such that this equation holds for t = horizon.

We now have all the ingredients to calculate risk free and risky duration

n
RiskFreeDuration = å DF (t i ) ⋅ DayCount (t i )
i =1

n
RiskyDuration = å DF (t i ) ⋅ ExpectedSurvival (t i ) ⋅ DayCount (t i )
i =1

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

We can now calculate expected incremental tranche loss occuring in the period from
ti-1 to ti

where ExpectedSurvival(0)= 1.

PD(t i , t i −1 ) = ExpectedSurvival (t i −1 ) − ExpectedSurvival (t i )

Given these default probabilities we can evaluate the contingent leg

n
PV (ContingentLeg ) = å PD(t i , t i −1 ) ⋅ DF (t i ) ⋅ TrancheSize
i =1
We are now also in a position to calculate the “Fair Spread” i.e. the spread at which
the PV of the contingent leg is equal to the PV of the fee leg

PV (ContingentLeg )
FairSpread =
RiskyDuration ⋅ TrancheSize

Then the MTM of the protection bought by the client given the actual spread paid is

MTM = ( FairSpread − Spread ) ⋅ RiskyDuration ⋅ TrancheSize

Note that both FairSpread and Spread have been quoted in Actual/360 quarterly
notation.

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

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Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

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 Lee McGinty Credit Derivatives Strategy
(44-20) 7325-5482 London
lee.mcginty@jpmorgan.com 6 May 2004

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