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

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  • Ingo Fender
  • John Kiff

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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Bibliographic 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
Date of revision:
Handle: RePEc:bis:biswps:163

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Related research

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

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Cited by:
  1. Byström, Hans N.E., 2008. "The Microfinance Collateralized Debt Obligation: A Modern Robin Hood?," World Development, Elsevier, Elsevier, vol. 36(11), pages 2109-2126, November.
  2. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration, University of Munich, Munich School of Management 10999, University of Munich, Munich School of Management.
  3. Ingo Fender & Martin Scheicher, 2009. "The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 19(24), pages 1925-1945.
  4. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration, University of Munich, Munich School of Management 11002, University of Munich, Munich School of Management.
  5. Rym Ayadi & Beat Bernet & Simone Westerfeld & Tom Franck & Nancy Huyghebaert & Vítor Gaspar & Simona Bovha-Padilla & Reinhilde Veugelers, 2009. "Financing of SMEs in Europe," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum, SUERF - The European Money and Finance Forum.
  6. Günter Franke & Markus Herrmann & Thomas Weber, 2007. "Information asymmetries and securitization design," CoFE Discussion Paper, Center of Finance and Econometrics, University of Konstanz 07-10, Center of Finance and Econometrics, University of Konstanz.
  7. Rym Ayadi & Beat Bernet & Simona Bovha-Padilla & Tom Franck & Nancy Huyghebaert & Vitor Gaspar & Reinhilde Veugelers, 2009. "Financing SMEs in Europe," SUERF Studies, SUERF - The European Money and Finance Forum, SUERF - The European Money and Finance Forum, number 2009/3 edited by Morten Balling & Beat Bernet & Ernest Gnan, July.
  8. François-Louis Michaud, 2005. "Gestion d'actifs et dérivés de crédit : opportunités et incertitudes," Revue d'Économie Financière, Programme National Persée, Programme National Persée, vol. 79(2), pages 79-93.
  9. Efraim Benmelech & Jennifer Dlugosz, 2009. "The Credit Rating Crisis," NBER Working Papers 15045, National Bureau of Economic Research, Inc.
  10. Ingo Fender & Janet Mitchell, 2005. "Structured finance: complexity, risk and the use of ratings," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, June.
  11. International Monetary Fund, 2012. "Are Rating Agencies Powerful? An Investigation Into the Impact and Accuracy of Sovereign Ratings," IMF Working Papers, International Monetary Fund 12/23, International Monetary Fund.
  12. Scholz, Julia, 2011. "Manager- und transaktionsspezifische Determinanten der Performance von Arbitrage CLOs," Discussion Papers in Business Administration, University of Munich, Munich School of Management 12144, University of Munich, Munich School of Management.
  13. Morkötter, Stefan & Westerfeld, Simone, 2009. "Rating model arbitrage in CDO markets: An empirical analysis," International Review of Financial Analysis, Elsevier, Elsevier, vol. 18(1-2), pages 21-33, March.
  14. Gann, Philipp, 2009. "Liquidität, Risikoeinstellung des Kapitalmarktes und Konjunkturerwartung als Preisdeterminanten von Collateralized Debt Obligations (CDOs) - Eine simulationsgestützte Analyse," Discussion Papers in Business Administration, University of Munich, Munich School of Management 10582, University of Munich, Munich School of Management.
  15. Fender, Ingo & Scheicher, Martin, 2009. "The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices," Working Paper Series, European Central Bank 1056, European Central Bank.
  16. Roberto Violi, 2010. "Credit ratings in structured finance and the role of systemic risk," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 774, Bank of Italy, Economic Research and International Relations Area.
  17. Roberts, John & Jones, Megan, 2009. "Accounting for self interest in the credit crisis," Accounting, Organizations and Society, Elsevier, vol. 34(6-7), pages 856-867, August.
  18. Rosenthal, Dale W.R., 2008. "Approximating correlated defaults," MPRA Paper 36788, University Library of Munich, Germany, revised 15 Feb 2012.
  19. Li L. Ong & Jorge A. Chan-Lau, 2006. "The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions," IMF Working Papers, International Monetary Fund 06/139, International Monetary Fund.

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