Correlation between the Recovery Rate and the State of an Economy - Application on the iTraxx

This paper studies the relationship between the recovery rate (RR) and the state of an economy (SE) in the traditional Monte Carlo credit risk model introduced by Li (1999) for the pricing of structured credit derivatives. This effect is significant if we consider extreme tranches of collateralized debt obligations (CDOs), because they are only reached when numerous defaults occur. The objective is to present a simple, intuitive and flexible approach for advanced financial products. The model is applied on a generic cash CDO and on the European iTraxx synthetic CDO index