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CREDIT RISK MODELS IV: UNDERSTANDING AND PRICING CDOs

  • Abel Elizalde

    ()

    (CEMFI, Centro de Estudios Monetarios y Financieros)

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    Some investors in the Collateralized Debt Obligations (CDOs) market have been publicly accused of not fully understanding the risks and dynamics of these products. They won't have an excuse any more. This report explains the mechanics of CDOs: their implied cash flows, the variables affecting those cash flows, their pricing, the sensitivity of CDO price to those variables, the functioning of the markets where they are traded, their different types, the conventions used for trading CDOs,...We built our description of CDOs pricing upon the Vasicek asymptotic single factor model because of its simplicity and the insights it provides regarding the pricing of CDOs. Additionally, we provide an extensive and updated review of the literature which extends the Vasicek model by relaxing its, somehow restrictive, assumptions in order to build more realistic and, as a consequence, more complicated CDO princing models.

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    File URL: http://www.cemfi.es/ftp/wp/0608.pdf
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    Paper provided by CEMFI in its series Working Papers with number wp2006_0608.

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    Date of creation: Apr 2006
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    Handle: RePEc:cmf:wpaper:wp2006_0608
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    1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    3. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
    4. Ang, Andrew & Chen, Joseph, 2002. "Asymmetric correlations of equity portfolios," Journal of Financial Economics, Elsevier, vol. 63(3), pages 443-494, March.
    5. Siem Jan Koopman & Andr� Lucas & Robert J. Daniels, 2005. "A Non-Gaussian Panel Time Series Model for Estimating and Decomposing Default Risk," DNB Working Papers 055, Netherlands Central Bank, Research Department.
    6. Thomas C. Wilson, 1998. "Portfolio credit risk," Economic Policy Review, Federal Reserve Bank of New York, issue Oct, pages 71-82.
    7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    8. Abel Elizalde & Rafael Repullo, 2004. "Economic And Regulatory Capital. What Is The Difference?," Working Papers wp2004_0422, CEMFI.
    9. Franke, Günter & Krahnen, Jan Pieter, 2005. "Default risk sharing between banks and markets: The contribution of collateralized debt obligations," CFS Working Paper Series 2005/06, Center for Financial Studies (CFS).
    10. Bank for International Settlements, 2005. "The role of ratings in structured finance: issues and implications," CGFS Papers, Bank for International Settlements, number 23, April.
    11. Daniel Covitz & Song Han, 2004. "An empirical analysis of bond recovery rates: exploring a structural view of default," Finance and Economics Discussion Series 2005-10, Board of Governors of the Federal Reserve System (U.S.).
    12. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
    13. 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.
    14. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    15. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
    16. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.).
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