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Credit rating impact on CDO evaluation

  • Rösch, Daniel
  • Scheule, Harald

One of the most significant developments in international credit markets in recent years has been the trade in Collateralized Debt Obligations (CDO), which has enabled financial institutions to repackage the credit risk of an asset portfolio into tranches to be transferred to investors. The present paper evaluates the credit risk of such a portfolio and the related tranches by applying two prominent prototypes for credit ratings, namely the point-in-time and through-the-cycle approach. The central parameters default probability and correlation are forecast for multiple years and related forecasting errors are included. The article's main findings are that banks which transfer debt tranches but retain an equity part and apply a through-the-cycle rating approach may be exposed to higher insolvency risk. Firstly, the credit risk retained may be underestimated resulting in an inadequate capital allocation. Secondly, the credit risk transferred may be overestimated resulting in additional risk-based transfer costs.

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File URL: http://www.sciencedirect.com/science/article/B6W4F-4TPF4G7-1/2/6745608623a01d155ffe198f9d60d270
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Article provided by Elsevier in its journal Global Finance Journal.

Volume (Year): 19 (2009)
Issue (Month): 3 ()
Pages: 235-251

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Handle: RePEc:eee:glofin:v:19:y:2009:i:3:p:235-251
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/620162

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  1. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
  2. Shumway, Tyler, 2001. "Forecasting Bankruptcy More Accurately: A Simple Hazard Model," The Journal of Business, University of Chicago Press, vol. 74(1), pages 101-24, January.
  3. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
  4. Crouhy, Michel & Galai, Dan & Mark, Robert, 2001. "Prototype risk rating system," Journal of Banking & Finance, Elsevier, vol. 25(1), pages 47-95, January.
  5. Rosch, Daniel, 2005. "An empirical comparison of default risk forecasts from alternative credit rating philosophies," International Journal of Forecasting, Elsevier, vol. 21(1), pages 37-51.
  6. Mark Carey, 1998. "Credit Risk in Private Debt Portfolios," Journal of Finance, American Finance Association, vol. 53(4), pages 1363-1387, 08.
  7. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Stability of ratings transitions," Bank of England working papers 133, Bank of England.
  8. Michael B. Gordy, 2002. "A risk-factor model foundation for ratings-based bank capital rules," Finance and Economics Discussion Series 2002-55, Board of Governors of the Federal Reserve System (U.S.).
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