Julius Finance releases white paper on CSO valuation for accounting purposes

Julius Finance last week released a white paper discussing the application of the FAS 157 accounting standard to tranches of synthetic credit default baskets. The paper focuses on the challenges of calibrating a fundamental dynamical basket model to liquid credit index tranches and the significant correlation effects between counterparty spreads and underlying trades in the credit valuation
adjustment calculations.

The paper also outlines the solutions that Julius Finance has developed to overcome these issues. The company's model assumes that the economy is driven by a latent Markov process and postulates a general functional form of how financial observables depend on it. It uses a heterogeneous recovery basket pricer to calibrate to groups of tranche and credit default swap prices, one group at a time. Then it uses model fusion technology to generate a joint distribution of defaults and recoveries that is consistent with lower-dimensional local distributions obtained in the previous step. The result is, according to the paper, is a dynamical, arbitrage-free, bottom up model which treats CDS, CDO and CDO-squared tranches in a uniform fashion.

The full paper can be downloaded here:
Julius Finance (PDF, 163.7 kb)