Risk Transfer with CDOs
AbstractModern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisite for solid risk management. This paper aims to resolve a part of the opaqueness surrounding credit-risk allocation to tranches that represent claims of different seniority on a reference portfolio. In particular, this paper analyzes the allocation of credit risk to different tranches of a CDO transaction when the underlying asset returns are driven by a common macro factor and an idiosyncratic component. Junior and senior tranches are found to be nearly orthogonal, motivating a search for the where about of systematic risk in CDO transactions. We propose a metric for capturing the allocation of systematic risk to tranches. First, in contrast to a widely-held claim, we show that (extreme) tail risk in standard CDO transactions is held by all tranches. While junior tranches take on all types of systematic risk, senior tranches take on almost no non-tail risk. This is in stark contrast to an untranched bond portfolio of the same rating quality, which on average suffers substantial losses for all realizations of the macro factor. Second, given tranching, a shock to the risk of the underlying asset portfolio (e.g. a rise in asset correlation or in mean portfolio loss) has the strongest impact, in relative terms, on the exposure of senior tranche CDO-investors. Our findings can be used to explain major stylized facts observed in credit markets.
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Bibliographic InfoPaper provided by Department of Finance, Goethe University Frankfurt am Main in its series Working Paper Series: Finance and Accounting with number 187.
Date of creation: Apr 2008
Date of revision:
Other versions of this item:
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-05-17 (All new papers)
- NEP-FMK-2008-05-17 (Financial Markets)
- NEP-RMG-2008-05-17 (Risk Management)
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