Levy Subordinator Model of Default Dependency

Abstract

This article presents a model of default dependency based on Levy subordinator. It is a tractable dynamical model, computationally structured similar to the one-factor Gaussian copula model, providing easy calibration to individual hazard rate curves and efficient pricing with Fast Fourier Transform techniques. The subordinator is an alpha=1/2 stable Levy process, maximally skewed to the right, with its distribution function known in closed form as the Levy distribution. The model provides a reasonable fit to market data with just two parameters to assess dependency risk, a measure of correlation and that of the likelihood of a catastrophe