Correlation smile...

Looks like the good old smile (or smirk) problem comes back in the credit derivatives market. We spent some time in the Derivatives class trying to understand why the smile exists in equity derivatives, which implies that the BS assumptions dont apply to the way the market prices these instruments.

Similarly, the one-factor Gaussian Copula model, while widely used, doesnt reflect market beliefs, thus producing an implied correaltion smile for the different tranches of say a CDX index. While an open ended question, some believe that its because the fat tails are not captured adequately by the gaussian copula model.