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CDOs and the financial crisis: Credit ratings and fair premia

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  • Wojtowicz, Marcin

Abstract

We study risk and return characteristics of CDOs using the market standard models. We find that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. Our results imply that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. This illustrates limitations of the rating methodologies that are solely based on real-world default probabilities or expected losses and do not capture risk premia. We also demonstrate that CDO tranches have large exposure to systematic risk and thus their ratings and prices are likely to decline substantially when credit conditions deteriorate.

Suggested Citation

  • Wojtowicz, Marcin, 2014. "CDOs and the financial crisis: Credit ratings and fair premia," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 1-13.
  • Handle: RePEc:eee:jbfina:v:39:y:2014:i:c:p:1-13
    DOI: 10.1016/j.jbankfin.2013.10.005
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. João M. Pinto & Mafalda C. Correia, 2017. "Are Covered Bonds Different from Asset Securitization Bonds?," Working Papers de Gestão (Management Working Papers) 01, Católica Porto Business School, Universidade Católica Portuguesa.
    2. repec:eee:jfinec:v:127:y:2018:i:3:p:505-518 is not listed on IDEAS
    3. Efing, Matthias, 2015. "Arbitraging the Basel securitization framework: Evidence from German ABS investment," Discussion Papers 40/2015, Deutsche Bundesbank.
    4. repec:oup:revfin:v:21:y:2017:i:2:p:465-509. is not listed on IDEAS
    5. Thomas Mählmann, 2016. "Market share and risk taking: the role of collateral asset managers in the collapse of the arbitrage CDO market," Review of Quantitative Finance and Accounting, Springer, vol. 47(2), pages 273-303, August.

    More about this item

    Keywords

    Collateralized debt obligations; Credit ratings; Fair premia; Structured finance; Rating agencies; Financial crisis;

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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