Tsui, L. K., 2011: A Multi-Factor Bottom-Up Model for Pricing Credit Derivatives. Journal of Computational Finance, forthcoming.

In this paper we continue the study of the stress event model, a simple and intuitive dynamic model for credit risky portfolios, proposed by Duffie and Singleton (1999). The model is a bottom-up version of the multi-factor portfolio credit model proposed by Longstaff and Rajan (2008). By a novel identification of independence conditions, we are able to decompose the loss distribution of a credit risky portfolio into a series expansion which not only provides a clear picture of the characteristics of the loss distribution but also suggests a fast and accurate approximation for it. Our approach has three important features: (i) it is able to match standard CDS index tranche prices and the underlying CDS spreads, (ii) its computational speed is very fast, comparable to that of the Gaussian copula model, (iii) the computational cost for additional factors is mild, allowing for more flexibility for calibrations and opening the possibility of studying multi-factor default dependence of a portfolio via a bottom-up approach. We demonstrate the tractability and efficiency of our approach by calibrating a three-sector model to investment grade CDS index tranches.

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