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

Author

Listed:
  • 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.

Suggested Citation

  • Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers 163, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:163
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    Citations

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    Cited by:

    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.
    2. 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.
    3. Pagnoncelli, Bernardo K. & Cifuentes, Arturo, 2014. "Credit risk assessment of fixed income portfolios using explicit expressions," Finance Research Letters, Elsevier, vol. 11(3), pages 224-230.
    4. 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.
    5. Peña Cerezo, Miguel Ángel & Rodríguez Castellanos, Arturo & Ibáñez Hernández, Francisco J., 2015. "Does rating shopping exist in spanish securitization issues?," Cuadernos de Gestión, Universidad del País Vasco - Instituto de Economía Aplicada a la Empresa (IEAE).
    6. Rosenthal, Dale W.R., 2008. "Approximating correlated defaults," MPRA Paper 36788, University Library of Munich, Germany, revised 15 Feb 2012.
    7. 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, vol. 19(24), pages 1925-1945.
    8. Byström, Hans N.E., 2008. "The Microfinance Collateralized Debt Obligation: A Modern Robin Hood?," World Development, Elsevier, vol. 36(11), pages 2109-2126, November.
    9. 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.
    10. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration 11002, University of Munich, Munich School of Management.
    11. John Kiff & Sylwia Nowak & Liliana B Schumacher, 2012. "Are Rating Agencies Powerful? An Investigation Into the Impact and Accuracy of Sovereign Ratings," IMF Working Papers 12/23, International Monetary Fund.
    12. Ingo Fender & Janet Mitchell, 2005. "Structured finance : complexity, risk and the use of ratings," Financial Stability Review, National Bank of Belgium, vol. 3(1), pages 127-135, June.
    13. Izabela Pruchnicka-Grabias, 2014. "The Influence Of Confidence Level, Correlation And Volatility On Value At Risk. Six Case Studies," Interdisciplinary Management Research, Josip Juraj Strossmayer University of Osijek, Faculty of Economics, Croatia, vol. 10, pages 565-581.
    14. Roberto Violi, 2010. "Credit ratings in structured finance and the role of systemic risk," Temi di discussione (Economic working papers) 774, Bank of Italy, Economic Research and International Relations Area.
    15. Efraim Benmelech & Jennifer Dlugosz, 2010. "The Credit Rating Crisis," NBER Chapters,in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207 National Bureau of Economic Research, Inc.
    16. Scholz, Julia, 2011. "Manager- und transaktionsspezifische Determinanten der Performance von Arbitrage CLOs," Discussion Papers in Business Administration 12144, University of Munich, Munich School of Management.
    17. Morkötter, Stefan & Westerfeld, Simone, 2009. "Rating model arbitrage in CDO markets: An empirical analysis," International Review of Financial Analysis, Elsevier, vol. 18(1-2), pages 21-33, March.
    18. Scheicher, Martin & Fender, Ingo, 2009. "The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices," Working Paper Series 1056, European Central Bank.
    19. François-Louis Michaud, 2005. "Gestion d'actifs et dérivés de crédit : opportunités et incertitudes," Revue d'Économie Financière, Programme National Persée, vol. 79(2), pages 79-93.
    20. 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, number 2009/3 edited by Morten Balling & Beat Bernet & Ernest Gnan.
    21. 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.

    More about this item

    Keywords

    Collateralised debt obligations; credit risk modelling; rating agencies;

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • 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

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