New answers tagged modern-portfolio-theory
The way to model the correlation may depend on the portfolio you have. For example you may model the default distribution for a small portfolio of loans using a mixed binomial model. In this case the state of the economy determine the probability of default, but in each scenario the individual defaults events share the same probability (homogeneity). Thus, ...
The correlation does not play any role for a linear portfolio, such as a CDS index, However, for a portfolio with nonlinear dependence on the loss of underlying entities, such as the case for a CDO or an $m$-th to default swap, the correlation plays a role. Here, certain techniques such as copula may be needed, depending on the complexity of the structure.
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