What role did Gaussian copula play in the 2008 financial crisis?

The Gaussian copula model (Li 2000) was used to price CDO tranches by modeling default correlation. Correlation inputs were estimated from CDS markets, which were historically shallow. The model underestimated tail correlation — assets defaulting together in stress — leading to severe underpricing of mezzanine CDO risk.

What is tranche attachment and detachment in CDO expected loss?

A tranche from 3% attachment to 7% detachment absorbs losses between 3% and 7% of the pool. Expected loss equals the probability-weighted average loss to the tranche across all simulated pool loss scenarios. Tranches closer to the equity bottom have higher expected loss and higher spreads.

CDO Expected Loss by Tranche

Calculate expected loss for each CDO tranche by modeling the pool loss distribution (using Gaussian copula or Monte Carlo simulation) and determining each tranche's exposure to losses above its attachment point.

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Frequently Asked Questions

What role did Gaussian copula play in the 2008 financial crisis?

What is tranche attachment and detachment in CDO expected loss?