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CDO rating methodology: Some thoughts on model risk and its implications

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Author Info
Ingo Fender
John Kiff

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Abstract

Rating collateralised debt obligations (CDOs), which are based on tranched pools of credit risk exposures, does not only require attributing a probability of default to each obligor within the portfolio. It also involves assumptions concerning recovery rates and correlated defaults of pool assets, thus combining credit risk assessments of individual collateral assets with estimates about default correlations and other modelling assumptions. In this paper, we explain one of the most well-known models for rating CDOs, the so-called binomial expansion technique (BET). Comparing this approach with an alternative methodology based on Monte Carlo simulation, we then highlight the potential importance of correlation assumptions for the ratings of senior CDO tranches and explore what differences in methodologies across rating agencies may mean for senior tranche rating outcomes. The remainder of the paper talks about potential implications of certain model assumptions for ratings accuracy, that is the "model risk" taken by investors when acquiring CDO tranches, and whether and under what conditions methodological differences may generate incentives for issuers to strategically select rating agencies to get particular CDO structures rated.

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Publisher Info
Paper provided by Bank for International Settlements in its series BIS Working Papers with number 163.

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Length: 31 pages
Date of creation: Nov 2004
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Handle: RePEc:bis:biswps:163

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Related research
Keywords: Collateralised debt obligations; credit risk modelling; rating agencies;

Find related papers by JEL classification:
C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Statistical Simulation Methods
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
G20 - Financial Economics - - Financial Institutions and Services - - - General

Cited by:
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  1. Gann, Philipp, 2009. "Liquidität, Risikoeinstellung des Kapitalmarktes und Konjunkturerwartung als Preisdeterminanten von Collateralized Debt Obligations (CDOs) - Eine simulationsgestützte Analyse," Discussion Papers in Business Administration 10582, University of Munich, Munich School of Management. [Downloadable!]
  2. Günter Franke & Markus Herrmann & Thomas Weber, 2007. "Information asymmetries and securitization design," CoFE Discussion Paper 07-10, Center of Finance and Econometrics, University of Konstanz. [Downloadable!]
  3. Byström, Hans, 2006. "The Microfinance Collateralized Debt Obligation: a Modern Robin Hood?," Working Papers 2006:14, Lund University, Department of Economics, revised 21 Aug 2006.
    Other versions:
  4. Li L. Ong & Jorge A. Chan-Lau, 2006. "The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions," IMF Working Papers 06/139, International Monetary Fund. [Downloadable!]
  5. Ingo Fender & Martin Scheicher, 2009. "Fiscal behaviour in the European Union - rules, fiscal decentralization and government indebtedness," Working Paper Series 1056, European Central Bank. [Downloadable!]
  6. Rosenthal, Dale W.R., 2008. "Data Delays, Index Deletions, Prepayments, and Defaults," MPRA Paper 8556, University Library of Munich, Germany. [Downloadable!]
  7. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration 10999, University of Munich, Munich School of Management.
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