medium · Frm Part 2 Market Risk
If a risk system models joint defaults using a Gaussian copula calibrated during a period of low volatility, why is it likely to understate the risk of a senior CDO tranche?
- The Gaussian copula overestimates the probability of idiosyncratic defaults.
- Gaussian copulas assume a Student-t distribution which has too much tail mass.
- The Gaussian copula lacks tail dependence, failing to capture clustered defaults in crises.
- Gaussian copulas are only applicable to equity markets, not credit markets.
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