Working Paper No. 407
By Joseph Noss
Structured credit instruments offer an insight into markets’ perceptions of the extent of future credit defaults. Claims of different seniorities incur losses only if defaults reach different magnitudes, so their relative value offers an insight into the likelihood of losses being of different severities. This paper matches the traded values of structured credit products by modelling the defaults of the underlying credits and their interdependence. It offers an improvement on the industry-standard ‘Gaussian copula’ model in its ability to capture the ‘tail event’ of multiple firms defaulting together. This allows policymakers to draw better inference as to the likely scale of defaults implied by structured credit prices. It offers an indication of the extent to which defaults are driven by systemic shocks to firms’ balance sheets. It may also be of use to those who trade structured credit products and may offer an improvement in risk management.