Comments on: Deconstructing the Gaussian copula, part II and a half http://www.thisisthegreenroom.com/2009/deconstructing-the-gaussian-copula-part-ii-and-a-half/ live from herzliya Thu, 09 Feb 2012 09:33:44 +0000 hourly 1 http://wordpress.org/?v=3.3.1 By: J http://www.thisisthegreenroom.com/2009/deconstructing-the-gaussian-copula-part-ii-and-a-half/comment-page-1/#comment-1295 J Tue, 18 Aug 2009 19:57:32 +0000 http://www.thisisthegreenroom.com/?p=2373#comment-1295 I think we need to make a distinction between bad inputs/assumptions and bad models. I don't see the SFGC as being a bad model even if someone is plugging constant 40% recoveries into it; that is more a case of bad analysis (to the extent that 40% recovery is unrealistic). That said, I agree with you that some sort of dynamic recovery is probably going to give a more informed answer - I question, however, whether the impact will be dramatically better than a well-informed (that is to say, regularly updated) set of static recovery assumptions. I think you hit the nail on the head when you note it comes down to a matter of horsepower. Can you afford to spend a few more cycles working through recovery distributions? Do you feel comfortable having your model decide how recoveries will behave in the future (or even specifying those distributions)? Of course, I'm always playing devil's advocate in favor of simplicity. I think we need to make a distinction between bad inputs/assumptions and bad models. I don't see the SFGC as being a bad model even if someone is plugging constant 40% recoveries into it; that is more a case of bad analysis (to the extent that 40% recovery is unrealistic). That said, I agree with you that some sort of dynamic recovery is probably going to give a more informed answer - I question, however, whether the impact will be dramatically better than a well-informed (that is to say, regularly updated) set of static recovery assumptions. I think you hit the nail on the head when you note it comes down to a matter of horsepower. Can you afford to spend a few more cycles working through recovery distributions? Do you feel comfortable having your model decide how recoveries will behave in the future (or even specifying those distributions)? Of course, I'm always playing devil's advocate in favor of simplicity.

]]> By: Sandrew http://www.thisisthegreenroom.com/2009/deconstructing-the-gaussian-copula-part-ii-and-a-half/comment-page-1/#comment-1285 Sandrew Fri, 14 Aug 2009 13:41:21 +0000 http://www.thisisthegreenroom.com/?p=2373#comment-1285 Thanks for the great write-up. But I'm a bit confused by your last two paragraphs. To me, the more relevant question is whether it is "bad" for a model to assume that recoveries are unchanging quantities. I think the answer is very clearly yes. A model that prices a 60-100 tranche as a risk-free bond (even absent prepayment risk) is not representative of reality, and its caretakers should get wise to this if they haven't already. Not that I'm claiming some special insight here, as I suspect most shops that use SFGC models have long since fixed the static recovery assumption. I think it would be interesting to compare two implied volatility surfaces: one using static recovery and one using some kind of dynamic recovery model. Maybe run the comparison both today and as-of some interesting historical dates--say, May 2007 and October 2008--to see if the differences in the surfaces are any more/less stark nowadays. Unfortunately, I don't have access to the horsepower to run it myself. Thanks for the great write-up.

But I'm a bit confused by your last two paragraphs. To me, the more relevant question is whether it is "bad" for a model to assume that recoveries are unchanging quantities. I think the answer is very clearly yes. A model that prices a 60-100 tranche as a risk-free bond (even absent prepayment risk) is not representative of reality, and its caretakers should get wise to this if they haven't already. Not that I'm claiming some special insight here, as I suspect most shops that use SFGC models have long since fixed the static recovery assumption.

I think it would be interesting to compare two implied volatility surfaces: one using static recovery and one using some kind of dynamic recovery model. Maybe run the comparison both today and as-of some interesting historical dates--say, May 2007 and October 2008--to see if the differences in the surfaces are any more/less stark nowadays. Unfortunately, I don't have access to the horsepower to run it myself.

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